A Deeper Dive On CLOs

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CLOs, or Collateralized Loan Obligations, are investment vehicles that pool together numerous leveraged loans, and have been popular among institutional investors for more than three decades. Although the individual loans that constitute a CLO are generally below “investment grade,” the unique structure of the CLO distributes risk in such a way that CLOs are popular among even the most conservative investors. The investment vehicles have evolved over time, along with increasing investor comfort levels and a substantial growth in the number of CLO issues and depth of the market.

Global outstanding CLO issues hit an impressive milestone in August of 2021, reaching $1 trillion for the first time. Nearly 80% of that total originated in the US, while the remaining 20% came primarily from European issuers. Annual issuance reached over $200 billion in the US over the past year, compared to $144 billion in the previous annual high, in 2018.1 Along with the surge in issuance has come an increase in trading of the CLO secondary market, with monthly dollar volume averaging approximately $11.5 billion per month over the past year.2

Graph: CLO Secondary Market Trends: December 2021 Edition, KopenTech Blog, 1/20/22

In addition to paying regular, standardized interest payments, CLO tranches are often rated by one or more rating agencies. The senior tranche is typically designed to receive a AAA rating, the highest credit rating available. According to the Federal Reserve, AAA-rated CLO tranches have never defaulted, including during the financial crisis that began in 2008.3 Furthermore, CLO rated tranches have offered investors a substantial premium compared to corporate bonds of the same rating and characteristics. Over time, the spreads of various CLO tranches and ratings have been relatively stable, particularly the spreads of the higher-rated issues.4 

Investors have migrated to the portion of the CLO that best fits their needs, generally as follows5:

CLOs are investment vehicles that are actively managed by an investment manager. The manager establishes the structure, identifies borrowers and investors, and selects the loans that make up the CLO investment. Although the tenor of CLOs vary from issue to issue, a general life cycle is common to most6:

As this diagram indicates, there are three overlapping periods that constitute the life of the CLO. During the initial phase, the “ramp-up” period, the investment manager raises capital for the CLO and constructs the initial portfolio with the purchase of a diversified selection of loans. Following the ramp-up period, the investment manager is free to buy and sell loans according to the covenants of the CLO. The investment manager therefore plays an important role in the CLO’s performance, since the selection of individual loans is a key ingredient in how the CLO performs.

The “no-call” period refers to the option available to the CLO’s equity investors to “call” the structure following the end of that phase. In other words, equity investors have the right to redeem their investment following the no-call period, leading to the winding up of the CLO and returning of investment proceeds to investors in all tranches. Often the exercise of the call feature requires the approval of the CLO’s manager. Equity investors may call an issue for a variety of reasons, including the availability of lower-cost financing options, or the realization of the profit that has accrued to them.

Following the designated reinvestment period, the investment manager allows the loans to mature or sells them on the secondary market, and the CLO structure is amortized. Investors in each tranche receive principal plus interest over time as the size of the CLO is reduced, until all outstanding loans have matured or been sold, and all payments to investors have been made.

As noted, the investment manager of the CLO plays a very important role, selecting loan issues and trading those loans throughout the life of the investment. The manager is not only responsible for active investment and risk management, but also ensures that the CLO passes various maintenance tests designed to protect investors, and that any new or existing loans comply with the terms of the investment covenants. Investment managers also ensure that the portfolio is well-diversified and that the value of each loan is under the designated maximum size to avoid large exposure to any single issuer.

Cash flows from the CLO’s pool of loans are distributed to investors according to a “waterfall,” or the priority schedule set forth in the CLO’s documents. Interest payments generated by the loans are used to pay interest first to senior noteholders, and then to less senior (mezzanine) investors. Equity investors are paid the balance of loan proceeds after noteholders have received interest payments in full. Because the interest payments of leveraged loans substantially exceed interest payments to senior and mezzanine investors, equity investors retain large investment upside in compensation for their additional investment risk.

CLOs have a long history throughout a wide variety of market cycles, including the major bear markets of 2000 and 2008, and the Covid epidemic of the past two years. Because CLOs offer floating rate interest payments that rise with interest rates, CLOs are usually well-positioned for rising rate environments. The key feature of CLOs is that investors can choose the investment that most closely matches their needs.

1. Global CLO Market Hits $1 Trillion Milestone, Neuberger Berman, 1/27/21

2. CLO Secondary Market Trends: December 2021 Edition, KopenTech Blog, 1/20/22

3. Who Owns U.S. CLO Securities?, Federal Reserve, 7/19/19,

4. Trends in CLO Collateral and Performance, Bloomberg Law, October, 2020

5. Who Owns U.S. CLO Securities?, Federal Reserve, 7/19/19

6. Who Owns U.S. CLO Securities?, Federal Reserve, 7/19/19

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