7 Sources of Built-In Risk Protection in CLOs for Income Investors

What explains the growing interest in CLOs from income investors worldwide?

Collateralized Loan Obligations (CLOs) have grown into a $1+ trillion asset class favored by a broad range of institutional investors. CLOs offer a long history of yield premiums, competitive total returns, and favorable risk characteristics.

We believe that the built-in risk protection of CLOs has been a key driver of growth for the asset class, as well as the recent entrance of private and individual investors into the CLO marketplace.

CLO Resilience

CLOs have demonstrated resilience in the most volatile market environments of recent years, including:

• the Great Financial Crisis of 2007 to 2009
• the energy and retail down cycle of 2015 to 2016
• the Pandemic of 2020

Of the 20,000+ CLO tranches rated by S&P Global since 1996, only 67 tranches, or 0.3% have ever defaulted.¹ There have been no defaults among AAA tranches, the most senior tranche in a CLO’s capital structure and the largest portion of investor capital.²

We believe this resilience is the result of the multifaceted risk protection built into CLOs. Protections offered by CLOs have been further enhanced by more stringent industry requirements put in place since the financial crisis.

The risk protection characteristics of CLOs encompass 7 broad categories:

1. Strength of Underlying Collateral

The “built-in risk protection” of the CLO structure starts with the underlying loan portfolios that serve as collateral. CLOs are backed by portfolios of senior secured loans, which have the most senior claim on the assets of a borrower in the event of default or bankruptcy. Leveraged loans within a CLO’s collateral portfolio are mostly made up of non-investment grade companies. However, the senior secured status of leveraged loans has translated into lower default rates and higher recoveries compared to unsecured high-yield bonds.

2. Floating Rate: Inflation Hedge & Low Interest Rate Risk

The underlying loan portfolios of CLOs are floating-rate loans, which have fluctuating coupons based on movements in interest rates. Thus, CLOs provide insulation to interest rate risk. As a result, CLOs can serve as a potential inflation hedge, since rising rates can accompany rising inflation.

3. Strict Diversification

CLOs operate under strict guidelines as determined by regulators and market participants in the leveraged credit market. These guidelines require broad diversification across borrowers and industries. The underlying CLO loan portfolios are generally diversified across 150 to 300+ borrowers with further diversification across 30+ industries, according to Moody’s.

Most CLOs are subject to strict loan portfolio concentration limits, subject to monthly monitoring, testing, and reporting by CLO trustees. CLO managers must satisfy these diversification requirements to avoid triggering trading restrictions.

4. Active Risk Management

Active risk management is a key attribute of CLOs. CLO managers have the ability to adjust loan holdings within the $1.4 trillion leveraged loan universe. Thus, CLO managers can dynamically manage credit quality across the economic and corporate lifecycle, replacing deteriorating credits with stronger loans. This process can enhance the overall health, credit quality, and performance of a CLO.

CLO managers can further mitigate risk by actively trading their loan portfolio’s to increase diversification across borrowers and industries or reducing exposures to low-quality credits.

5. Robust Credit Support for Senior Tranches

The CLO structure requires junior tranches to absorb losses before the most senior tranches. This is called “subordination.” As a result of the financial crisis, the CLOs of today require higher levels of subordination. According to a study by the Federal Reserve Bank of Philadelphia, “the AAA-rated portion of the [CLO] capital structure decreased from 72% … to 61%” post-crisis. This provides greater credit support to the investment grade CLO tranches during periods of elevated economic and market stress.

Source: “CLO Performance,” Larry Cordell (Federal Raserve Bank of Philadelphia,
Michael R. Roberts (UPenn/Wharton), and Michael Schwert (UPenn/Wharton); Feb. 4, 2021

6. Self-Healing Structure

CLOs provide a self-healing structure that actively manages credit deterioration and helps mitigate risk. 

CLOs are governed by mandated collateral and interest coverage tests, which affirm that underlying portfolios are able to meet its interest and principal obligations to the CLO debt holders. These coverage tests are monitored and reported monthly by the trustee of a CLO. Some of the most important of these tests are the interest coverage and over-collateralization tests. These tests are vital in detecting and correcting credit deterioration and can directly affect the allocation of cash flows among CLO tranches.

• Interest coverage tests require that the income generated by underlying loan portfolios (assets) must be greater than the interest due to outstanding CLO debt tranches (liabilities).
• Over-collateralization tests require that the principal (par) amount of the underlying loan portfolios is greater than the principal (par) amount of outstanding CLO debt tranches.

If an over-collateralization test comes up short, the CLO must divert cash flows from the CLO equity tranches (or even the junior debt tranches) to retire the most senior tranches and reduce the leverage in the CLO structure. Cash flows to the equity (and junior) tranches can resume once test results move back into compliance.

As additional structural protection, CLOs may also have an interest diversion test for the lowest-rated debt tranche. This test is similar in calculation to the over-collateralization test. However in this instance, instead of diverting cashflows to de-lever the CLO structure, , cash flow is diverted from the equity tranches to purchase additional loans for the portfolio thereby increasing the CLO’s collateral balance.

7. Insulation from Volatility: the Non-Mark-to-Market CLO Structure

The coverage tests above highlight the distinctive non-mark-to-market financing structure of CLOs, which insulates investors from short-term market volatility. The coverage tests are based on interest payments and the par value (rather than market value) of the loans.

As a result, market declines can provide CLO managers with the opportunity to buy loans at lower prices. Buying “cheap” enables CLO managers to build par value and increase the notional amount of the underlying loan portfolio, improving the level of collateral to the benefit of all tranches.

This increase in interest-paying assets can also provide additional profits to CLO equity holders. The improving arbitrage between increasing interest payments from underlying loans and the fixed payments to CLO debt tranches can enhance returns to CLO equity holders.

CLOs: Spectrum of Built-In Risk Protection

CLOs have been a resilient asset class across multiple market environments. As discussed above, the CLO structure offers a variety of built-in risk protection features. We believe this makes CLOs worthwhile for investors exploring alternative sources of income.

Today, there is growing concern that central bank actions may negatively impact the economy and credit markets. We believe that CLOs are structured to meet these challenges and have proven their resiliency over many market environments.

Next Steps

To learn more, download our FREE eBook: 13 Powerful Benefits of CLOs for Today's Income Investor (and 7 Risks to Know).

1. S&P Global, “Default, Transition, and Recovery: 2021 Annual Global Leveraged Loan CLO Default and Rating Transition Study.” (October 31, 2022)

https://www.spglobal.com/ratings/en/research/articles/221031-default-transition-and-recovery-2021-annual-global-leveraged-loan-clo-default-and-rating-transition-study-12535652

2. Michael R. Roberts and Michael Schwert, “Why Collateralized Loan Obligations Will Not Cause the Next Financial Crisis,” Knowledge at Wharton. (August 10, 2020)

https://knowledge.wharton.upenn.edu/article/clos-will-not-cause-next-financial-crisis/