How Do CLOs Work?

As investors continue to look high and low in their hunt for yields, collateralized loan obligations (CLOs) are drawing more and more attention. However, some investors may be put off by their intricate nature. Indeed, CLOs are an often misunderstood sector of structured credit. But the unalloyed fact is that CLOs have pretty much always performed well relative to other fixed-income strategies. 

In fact, the market for portfolios of arbitrage CLOs, which most CLOs are, is valued at $959 billion globally, with some 83 percent issued in the United States, according to Bank of America Global Research.

Having said that, let’s look at how CLOs work.

Just What is a CLO?

Essentially, a CLO is a security backed by a pool of loans. So, basically, collateralized loan obligations are repackaged loans investors can purchase. 

Can You Tell Me How They Work?

With CLOs, debt payments derived from their underlying loans are placed in a pool and allocated to investors of various CLO “tranches’’– collections of securities grouped based on various characteristics.

For example, rated in increasing order of risk and return, there’s a AAA debt tranche, a AA debt tranche, an A debt tranche, a BBB debt tranche, and so on, ending with the equity tranche, which provides the highest default rate as well as the highest return. Investors can opt to put money in whichever tranche suits their needs and objectives.

We mentioned “underlying loans” above. These are mostly made up of first-lien senior-secured bank loans, plus second-lien loans and unsecured debt. Debt payments that are made on these loans are pooled together and allocated to investors, beginning at the tranche’s top and working down to the bottom.

The bottom of the tranche carries the most risk. That’s just part of CLO characteristics.  However, it also produces the highest return. 

How are CLOs Created?

They basically are created like this:

• The CLO manager crafts a capital structure of tranches with a variety of risk and return expectations.
• Capital is raised from investors.
• Investors select a tranche suiting their profiles.
• The CLO manager uses the capital garnered from investors to buy loans.
• Interest gained from the loans goes to investors, beginning at the highest tranche.

What are Some Benefits of CLOs (Collateralized Loan Obligations)?

Investors have several advantages when it comes to CLOs:

• Floating-rate loans. These are the underlying loans of collateralized loan obligations. In effect, this results in a low duration. Thus, such obligations are at risk from interest rate changes.
• Over-collateralization. Even if several loans default, the high-ranking tranches are not affected. This renders higher-ranking CLO tranches over-collateralized. So, if a loan defaults, the lower tranches sustain losses first.
• Close management. A loan manager, or managers, actively manage and monitor CLOs. While such managers do collect fees, such fees are typically tied to CLO performance.
• Protection against inflation. CLOs can be used as a hedge against protection because they are made up of floating-rate loans.
• Better returns. At length, collateralized loan obligations have typically outperformed other corporate debt classifications such as bank loans, investment-grade bonds, non-investment-grade bonds, and so on.

Now you have a good idea of how collateralized loan obligations work. Such loans are a bit complex, but as you can see, they do come with benefits. In the meantime, if you’re looking to diversify your portfolio through alternative investments, and create passive income streams in doing so, the alternative investment platform Yieldstreet has multiple opportunities for mainstream investors across asset classes including art, commercial real estate, and more.