What is a CLO?

Collateralized loan obligations (CLOs) are actively managed investment products comprised of a diversified pool of leveraged loans that generate cash flow as they are repaid. CLOs allow investors to access the leveraged loan asset class in an efficient and structured way.

What are leveraged loans? 

The leveraged loan asset class has grown tremendously, resulting in increased liquidity and institutional scale over the last two decades. Once considered a niche, the asset class has grown to over $1 trillion, now on par with high-yield bonds. 

Put simply, CLOs are entities that purchase hundreds of leveraged loans made to non-investment-grade corporate borrowers across diverse industries. Leveraged loans are floating-rate loans, which typically produce higher income in higher interest rate environments compared to fixed-rate loans or high-yield bonds. They are typically the most senior security in a corporate borrower’s capital structure. Therefore, they are entitled to be paid back before any high-yield bonds or common equity of the company in the event of bankruptcy or default. These loans are usually assigned ratings by credit agencies and secured by the company’s assets (inventory, real estate, property, and equipment). Historically, they have had higher recovery rates compared to unsecured loans and highyield bonds. 

As borrowers pay the interest (and eventually, the original borrowed amount) on their loans, these cash flows go to the CLOs that own the loans. The CLOs then redistribute the cash flows to their investors according to a specific schedule of payments, predetermined by the structure of the CLO.

Features of CLOs 

CLOs bundle corporate leveraged loans into structures that are divided into tranches (slices), or layers of risk, and sold to investors depending on their differing risk-return objectives. Unique features of the structure are summarized below: 

• Tranche: French for “slice.” A CLO is comprised of several tranches, each representing a different level of risk. In a typical CLO, roughly 75% to 90% of the structure is created to be floating-rate senior and mezzanine debt tranches, with the remainder consisting of the equity tranche. Credit agencies typically rate CLO debt tranches from investment grade (most likely to be repaid) at the most senior level to below investment grade (less likely to be repaid). The lowest tranches, known as equity tranches, experience losses first due to the payment priority structure.
  • Senior debt tranche: This tranche has the lowest yields, lowest risk of principal loss, and is the first to receive cash flows (principal and interest payments) that come to the CLO from the pool of leveraged loans.
  • Mezzanine debt tranche: This tranche offers higher yields than senior tranches but only receives cash flows after the senior tranches have been paid, so it carries a higher risk of loss.
  • Equity tranche: This tranche is last to receive the cash flows (principal and interest payments from the leveraged loan pool). However, it is structured such that if all the loans continue to pay their principal and interest, it will have the highest returns within the CLO structure. Conversely, the equity tranche will also take losses first if the loans default on their payments to the CLO.
• Priority of payments: Often referred to as the “payment waterfall,” this refers to the sequential order in which cash flows derived from the underlying loans are allocated to the CLO fund investors. Put simply, investors in the highest-rated tranche receive interest and principal payments first, while investors in the lowest-rated tranche—typically the equity tranche—receive payments only after all investors in higherrated tranche are paid back in full. Note that investors may choose which debt tranches to invest in. 
  Economically, a CLO’s equity tranche, while potentially the highest returning, is also the riskiest portion. If some of the loans stop making payments (default), those payments will not reach the equity tranche, resulting in lower returns for this tranche. Exhibit 1 shows the priority of cash flows and sequence of losses.

Why do people invest in CLOs? 

CLOs allow investors to access the leveraged loan asset class in an efficient and targeted way, offering a wide array of securities across the risk spectrum. 

CLOs typically offer higher yields than comparably rated government and corporate bonds. Further, the floating interest rate payments (a spread above a benchmark rate) provide higher income in rising interest rate environments compared to fixed-rate instruments. 

CLOs employ a variety of mechanisms to limit, detect, and correct any deterioration of underlying loans. Moreover, a typical CLO holds over 200 individual leveraged loans that are spread across many different industries. This high level of diversification helps mitigate the default risk of any single company or industry. In short, CLOs are but another tool for diversified return enhancement.

What are the risks of CLOs? 

Like any investment strategy, CLOs come with some risks, including: 

• Complexity: CLOs are complex investment vehicles that have unique features. The various tranches have different levels of risks, while payments to investors follow a specific priority schedule. As such, it is recommended that investors conduct proper due diligence before investing in a CLO product.
• Credit risk: By their nature, CLOs are exposed to the credit risk of the underlying loans. If the underlying loans default— meaning the borrower fails to repay the loan—this can result in losses for investors.
• Prepayment risk: Though this may not initially seem to be a risk, investors may miss out on potential future interest income if underlying loans are paid in full before their maturity date.
• Reinvestment risk: As the fund receives cash proceeds from interest, and ultimately full payments on the underlying loans, the fund manager may reinvest this cash into additional loans for a specified period. There is a risk, however, that newly purchased loans may not generate as much cash flow as the original loans.

Important information 

This information is based on the views of, and provided by, SEI Investments Management Corporation (SIMC), a registered investment adviser and wholly owned subsidiary of SEI Investments Company. This information should not be relied upon by the reader as research or investment advice or recommendations (unless SIMC has otherwise separately entered into a written agreement for the provision of investment advice regarding the subject matter of this material).