What are CLOs, why do AAA CLOs stand out, and why do investment managers use them?

In brief

• CLOs are securities backed by diversified pools of corporate loans and are split into different tranches ranging from the safest AAA rated to the riskier BB rated and equity.
• AAA-rated CLOs combine high credit quality, floating-rate exposure, and structural protections.
• AAA-Rated CLOs have not experienced any principal losses historically – although past performance is no guarantee of future outcomes – and are considered the most liquid tranche among CLOs.
• They are widely used by institutional investors, including pension funds, insurers and asset managers.
• They may offer income and diversification benefits.
• They are more complex than traditional bonds.
• Most retail investors gain exposure to AAA CLOs through professionally managed funds rather than investing directly.

Fixed income funds typically seek to generate regular income by investing in bonds and other forms of debt issued by governments and companies, while helping to diversify a broader investment portfolio.

To achieve these objectives, investment managers invest across different areas of the fixed income market. One of these is collateralised loan obligations (CLOs), which are backed by diversified pools of loans made to companies.

While CLOs are less well known than government or corporate bonds, they have been part of credit markets for decades and are widely used by pension funds, insurers and investment managers. Most individual investors access CLOs through professionally managed funds rather than investing directly.

What are CLOs?

A collateralised loan obligation (CLO) brings together a large number of loans made to companies and packages them into a single investment. The underlying loans are typically made to companies with higher levels of debt and are known as leveraged loans.

By pooling many loans together, CLOs provide exposure to a diversified range of borrowers and sectors rather than relying on a single company. Investors buy CLO tranches, which are ordered from ‘AAA-rated’ (very high credit quality) all the way to ‘B-rated’ and equity (the riskiest part of the CLO structure). Senior tranches (such as AAA and AA rated CLOs) benefit from collateral behind the loans and through diversification of the underlying loans. Losses on the underlying loan portfolio are first absorbed by the lower-rated debt and equity tranches. The less senior the tranche, the higher the potential return, as a reward for taking on greater risk. 

Why do investment managers invest in CLOs?

Investment managers may invest in CLOs because they can offer a combination of income, diversification and access to a broad range of corporate loans.

Because CLOs are backed by loans to many different companies, they can help spread risk across multiple borrowers and sectors. In addition, both the underlying loans and CLO tranches are typically floating rate, meaning the income they generate can adjust as interest rates change.

Many fixed income managers focus on higher-rated CLO securities, which are designed to offer a different balance of risk and return from the underlying loans. Even the highest quality AAA CLOs, which have never defaulted to date, can offer higher income than some traditional high-quality fixed income investments, although this reflects factors including complexity, market conditions and investor demand.

CLOs generate returns from the interest paid on the loans they hold. Borrowers make regular interest payments, which are passed through to investors. Returns depend on factors including the performance of the underlying loans, market conditions and the level of risk associated with a particular CLO investment.

What are the risks?

Like all investments, CLOs carry risks and returns are not guaranteed.

Borrower defaults

The loans within a CLO are typically made to companies with below-investment-grade credit ratings. If borrowers experience financial difficulties and fail to repay their loans, the value of the CLO may be affected. For AAA CLOs, default risk is generally considered very low due to their structural protection, with a significant buffer provided by the subordinated tranches beneath them. Even if the underlying loans see large defaults, the AAA tranche will be paid first at the expense of the more junior tranches. Losses would need to exceed substantial levels before affecting AAA investors.

Economic downturns

A weaker economy can put pressure on company earnings and increase the likelihood of defaults, potentially reducing returns.

Market volatility 

The value of CLOs can fluctuate as investor sentiment, credit conditions and expectations for economic growth change.

Liquidity risk 

In stressed market conditions, CLOs may be harder to buy or sell than some traditional bonds, which can lead to greater price volatility. Although AAA CLOs are generally the most liquid segment of the CLO market, liquidity can still be lower than in some government bond markets and may deteriorate during periods of stress.

Interest rate and credit spread risk 

Although CLOs are backed by floating-rate loans, their market value can still be affected by changes in interest rates and the level of compensation investors demand for taking credit risk. Higher rates can also increase borrowing costs for the companies behind the loans.

Complexity risk

CLOs are more complex than many traditional fixed income investments and require specialist expertise to analyse and manage.

The bottom line

CLOs are a specialist area of fixed income investing that provide access to diversified portfolios of corporate loans. Investment managers may use them to help generate income, diversify risk and access opportunities beyond traditional government and corporate bonds.

While CLOs can offer potential benefits, they also carry risks, including borrower defaults, market volatility and changing economic conditions. For most investors, exposure is gained through professionally managed funds, where CLOs form just one part of a broader investment strategy.

AAA-rated CLOs have historically offered higher yields than some other AAA-rated securities. This is generally attributed to their complexity, specialist investor base and market structure, rather than an expectation of higher credit losses.

As ever, the value of investments and any income from them can fall as well as rise, and investors may get back less than originally invested.