Understanding Collateralized Loan Obligations (CLOs)

Summary

Collateralized loan obligations (CLOs) are typically a high yielding, scalable, floating-rate investment alternative to corporate bonds with a history of stable credit performance. CLOs represent a $1.4 trillion asset class within the broader $13.3 trillion structured credit fixed-income market—which also includes asset-backed securities (ABS) and mortgage-backed securities (MBS), among other similar securities—and derive principal and interest from an actively managed, diversified pool of non-investment grade, senior-secured corporate loans.

These loans, also known as bank loans or leveraged loans, typically occupy a first-lien position in the company’s capital structure. They are secured by the borrower’s assets, and rank first in priority of payment ahead of unsecured debt in the event of bankruptcy.

CLOs’ combination of diversified, actively managed, senior-secured loan collateral, along with robust securitization structures, has resulted in historically strong ratings performance and low default rates across the credit ratings spectrum, comparing favorably to corporate debt.

Investing in CLOs is not without risk. As with other securities, CLOs are subject to credit, liquidity, and mark-to-market risk. The basic architecture of CLOs requires that investors must understand the order in which the cash flows from the underlying portfolio are distributed to investors, known as waterfall mechanisms, as well as the protections, terms, conditions, and credit profile of the loan collateral. 

Still, CLOs have several features that make them an integral component of Guggenheim’s fixed-income strategies. One of the most important characteristics of CLOs is their floating-rate coupon, making their price less sensitive to changes in interest rates.

Report Highlights

• CLOs represent a high yielding, scalable, floating-rate investment alternative with a history of stable credit performance.
• Solid credit performance through the Global Financial Crisis (GFC) and COVID-19 risk cycles has supported growth in the CLO market, broadened the investor base, and supported secondary market liquidity.
• Guggenheim Investments’ long-term experience mobilizing credit research, structural analysis, analytical infrastructure, and legal expertise positions us to potentially capture the attractive relative and fundamental value in CLOs throughout a cycle.

Overview: What Are CLOs?

CLOs are a $1.1 trillion asset class within the broader $13.3 trillion structured credit fixed-income market¹, which also includes ABS and MBS. CLOs derive principal and interest from an actively managed, diversified pool of non-investment grade, senior-secured corporate loans.

CLOs issue debt and equity to investors and use the funds to acquire a diverse portfolio typically comprising more than 200 loans. The debt is divided into tranches with varying risk and return profiles, determined by their seniority and priority in receiving cash flows from the loan pool.

These underlying loans, also known as bank loans or leveraged loans, typically hold a first-lien position in the company’s capital structure, are secured by the company’s assets, and rank first in priority of payment ahead of unsecured debt in the event of bankruptcy. Economically, CLO equity investors own the loan pool, while the CLO debt investors provide term financing to acquire the pool of loans.

Understanding CLO Collateral: Leveraged Loans

A portfolio of loans serves as the collateral backing a CLO. These loans are typically extended to non-investment grade borrowers to finance a range of activities, including mergers and acquisitions, stock repurchases, dividend payments, leveraged buyouts, or new projects. The loans are arranged by investment banks and provided by a group or “syndicate” of institutional lenders.

Most of the loans in the CLO collateral are senior secured, or first-lien, loans that have priority claims on the borrower’s assets in a bankruptcy, making CLOs relatively lower risk investments. These loans carry floating-rate coupons, typically benchmarked to the Secured Overnight Financing Rate (SOFR), and include covenants—such as financial tests and restrictions on borrowers’ actions to protect lenders. The senior secured position of these loans has contributed to higher historical recoveries in default scenarios than those seen in the high yield bond market.

Understanding CLO Structures

At its inception, a CLO raises money to purchase a portfolio of loans by selling various debt and equity tranches to investors. Each tranche has a different claim priority on the cash received from the loan pool and exposure to loss from the underlying collateral pool. Cash flow distributions begin with the senior-most debt tranches of the CLO capital structure and flow down to the junior-most equity tranche—a distribution method referred to as a waterfall. The cash flow waterfall and a suite of performance tests and collateral concentration limits provide varying degrees of protection to the CLOs’ debt tranches.

The CLO’s most senior and highest-rated AAA tranche carries the lowest coupon but is entitled to the highest claim on the cash flow distributions and is the most loss-remote. Mezzanine tranches pay higher coupons but are more exposed to loss and have lower ratings. The most junior and riskiest part of the CLO capital structure is the equity tranche, which is neither rated nor coupon bearing. Instead, the equity tranche represents a claim on all excess cash flows that remain once the obligations for all debt tranches have been met. In a typical CLO structure, the AAA senior tranches are the largest, usually comprising around 65 percent of the capital structure. Mezzanine tranches, rated AA to BB-rated, are much smaller, usually making up 4–12 percent each. The equity tranche, which absorbs initial credit losses, varies in size but typically accounts for about 8–10 percent of the capital structure.

CLOs are governed by a series of coverage tests that measure the adequacy of the collateral balance and the cash flows generated by the underlying bank loans. One such test is an overcollateralization test (OC test), which ensures the principal value of the loan pool exceeds the outstanding principal of the CLO debt tranches. If the collateral’s principal value falls below the OC test trigger, cash that would have gone to the equity and junior tranches is instead redirected to pay down senior debt. Another test computes interest coverage (IC test), which ensures sufficient interest income to cover CLO tranche payments. If interest collections decline below the IC test trigger, cash is similarly diverted from equity and junior tranches to senior debt tranche investors.

CLOs are also subject to various collateral concentration limits designed to minimize risk in the bank loan collateral pool and protect CLO investors from loss. These limits include requirements for industry diversification in the loan pool, caps on exposure to non-senior secured loans and single obligors, and limitations on the share of CCC-rated loans, helping contain overall default risk.

Most CLO portfolios are actively managed. Over a defined reinvestment period, the collateral manager seeks to mitigate losses from loan defaults and optimize the bank loan portfolio’s value by actively managing the portfolio’s holdings. CLOs are not subject to mark-to-market tests and rely solely upon cash flow performance—or the timely payment of principal and interest—ratings, maturities, and defaults. As a result, CLO managers are not forced sellers during periods of market volatility and can actively trade loans to capture value or minimize losses on deteriorating credits.

Comparing Middle Market and Broadly Syndicated CLOs

While most CLOs are backed by broadly syndicated loans (BSL), a smaller but growing segment of the market is middle market (MM) CLOs—also referred to as private credit (PC) CLOs. MM CLOs are tied to the expanding private credit markets, where non-bank lenders such as private debt funds, business development companies (BDCs), and insurance companies provide loans directly to companies, bypassing the bank loan syndication process.

BSL CLOs are backed by loans to larger borrowers, typically with earnings before interest, taxes, depreciation, and amortization (EBITDA) greater than $250 million, and held by multiple lenders (i.e. syndicated). In contrast, MM CLOs are backed primarily by private, directly originated loans to small and medium-sized borrowers, typically with EBITDA between $50–$100 million, and often containing tighter documentation. Some MM CLO managers also specialize in loans to larger borrowers, with EBITDA greater than $100 million, blurring the line between middle market and broadly syndicated loans as private credit becomes more accessible to larger companies.

Historically MM CLO issuance accounted for 10–12 percent of overall CLO issuance, but in recent years this figure rose to as high as 24 percent. Currently, MM CLOs represent 12.4 percent of the total CLO amount outstanding, double the percentage from a decade ago.

Collateral quality is a key differentiator between BSL and MM CLOs, as MM CLOs have much greater CCC-rated exposure. Due to the poorer credit quality of the underlying collateral, MM CLOs offer higher credit enhancement relative to BSL for similarly rated tranches, such as overcollateralization, to help offset the risk. Middle market loans also tend to have higher spreads and are usually assigned a private credit estimate rather than a public rating. Liquidity is another major distinction between the two markets, as the underlying collateral of BSL CLOs is much more liquid, with greater pricing transparency, than the collateral of MM CLOs.

Due to the poorer credit quality of the underlying collateral, MM CLOs offer higher credit enhancement relative to BSL for similarly rated tranches, such as overcollateralization, to help offset the risk. Middle market loans also tend to have higher spreads and are usually assigned a private credit estimate rather than a public rating.

Comparing Middle Market and Broadly Syndicated Loan CLOs

Source: Guggenheim Investments.

Manager selection is of paramount importance for MM CLOs as there is less transparency into the underlying loan performance, given the private, directly originated nature of the collateral. A key differentiator in assessing CLO managers is their ability to source and access attractive opportunities, as deal flow tends to be relationship-driven and dependent on direct engagement with private equity sponsors and company management teams. In the event of underperformance or default, limited secondary market liquidity means managers may need to engage directly in restructuring negotiations, recapitalizations, or covenant amendments. As such, a manager’s ability to navigate distressed situations, maintain sponsor relationships, and preserve investor value is critical. For investors in MM CLOs, evaluating a manager’s origination, underwriting, investment strategy, restructuring capabilities, and track record is essential.

Historical Performance

The combination of diversified, actively managed, senior-secured loan collateral and robust securitization structures has led to favorable historical ratings performance. According to Standard & Poor’s, CLO 1.0s (those issued before the GFC) performed well during the financial crisis, with minimal lifetime defaults. CLO 2.0s (those issued post-GFC) feature numerous additional credit enhancements beyond those in pre-crisis vintages.

First, rating agencies now require substantially more overcollateralization in CLOs than before the GFC. Second, while pre-crisis CLOs often invested meaningfully in subordinated bonds and other structured credit instruments, post-crisis CLOs are almost entirely backed by senior secured bank loans. Third, post-crisis deal documentation is much more investor friendly, for example, by shortening the trading period during in which the manager can actively manage the loan portfolio and limiting extension risk for CLOs. Thanks to these enhancements, CLO 2.0s have out-performed CLO 1.0s. At the same time, CLOs have maintained a historically low default rate across the ratings spectrum comparing favorably to corporate debt.

Investing in CLOs

CLOs have several features that make them an integral component of Guggenheim Investments’ fixed-income strategies. In addition to their investor-friendly structural protections and historical credit performance, one of the most important characteristics of CLOs is their floating-rate coupon, which helps insulate bond prices from volatile interest rates. Fixed-rate securities decline in value as interest rates rise and investors discount the value of the fixed-rate bonds’ relatively low coupons. However, the coupons on floating-rate securities such as CLOs adjust based on the current short-term interest-rate environment. As a result, floating-rate securities’ prices tend to be more stable in volatile interest-rate environments than those of their fixed-rate counterparts.

Investing in CLOs is not without risk. As with other securities, CLOs are subject to credit, liquidity, and mark-to-market risk, and investors must understand the waterfall mechanisms and protections as well as the terms, conditions, and credit profile of the underlying loan collateral. Thus, the relative value determination for a CLO simultaneously considers potential returns relative to other securitized and corporate fixed-income sectors as well as its pricing relative to other short-duration options.

Capturing opportunities in the CLO market requires the expertise to perform bottom-up research on individual bank loans in the underlying collateral pool. Because CLOs routinely have over 200 issuers in their collateral pools, investment managers must have significant corporate credit research capabilities to fully evaluate the underlying credit risk in each CLO.

The importance of understanding a CLO’s structural characteristics cannot be underestimated. Two CLOs with the identical collateral assets may perform differently due to structural differences. The legal documentation that governs a typical CLO can be more than 300 pages, and a high degree of expertise and consistent market presence are required to analyze these documents and discuss key terms with managers looking to access the market. The ability to access the value in CLOs becomes available to investors with the appropriate mix of credit research, structuring experience, and legal expertise.

The Guggenheim Approach

Guggenheim Investments’ approach to investing in CLOs is consistent with our process for all our fixed-income investments. With CLOs, the investment process starts with a bottom-up fundamental approach to CLO structures. Guggenheim brings to bear its extensive research insights across a broad spectrum of the bank loan market and the structuring and legal expertise necessary to understand the nuances of each individual CLO investment opportunity. Collateral, structure, and manager attributes are evaluated, and stress testing and scenario analyses are performed. Research is augmented by our in-house legal team and by the obligor-level credit views of our corporate credit team. Investments are integrated into portfolio strategies by considering relative value, risk, and sector targets, as well as the risk-adjusted return potential evaluated from a long-term holding period point of view.