Collateralized Loan Obligation (CLO)

A CLO is a type of collateralized debt obligation backed by a diversified portfolio of senior secured loans, typically to companies with below-investment-grade credit ratings, often owned by private equity firms. A CLO manager selects and actively manages the loans.

The CLO issues notes in tranches. Interest and principal from the loans flow to investors in order, with senior tranches paid first. Junior tranches and the equity tranche absorb losses first but receive higher returns.

For example, a CLO might hold 400 loans worth 500,000,000 in total, issuing AAA-rated notes making up about 60% of its funding, lower-rated notes for the next layers and equity at the bottom.

CLOs are major buyers of leveraged loans, providing much of the funding for leveraged buyouts. Unlike mortgage-backed CDOs, CLOs performed relatively well during the 2008 financial crisis, with very few losses on senior tranches. They include protections such as tests that divert cash to senior investors if loan quality deteriorates. Junior tranches and equity can still suffer significant losses in recessions.