Home > Resources > Video Library > Understanding Collateralized Loan Obligations (CLOs)
Investment Strategies

Understanding Collateralized Loan Obligations (CLOs)

Here we discuss the fundamentals of collateralized loan obligations (CLOs) and why CLO equity investors may benefit from widening credit spreads.

More from this section

Read Transcript

Loren Sageser, Credit Strategist: A CLO is a securitized vehicle which borrows money from debt and equity investors to invest in a portfolio of floating rate corporate bank loans, and the portfolio is actively managed by a professional investment manager.

CLOs have been around since the mid-1990s and provide investors with an opportunity to take advantage of complexity and illiquidity premia.

Chart: The chart is a graphical representation of how a CLO works. One bar depicts assets (portfolio of bank loans) with declining cash flows. The second bar depicts liability tranches with realized losses from bank loans increasing.

When a CLO is newly issued, the money for the portfolio of bank loans is raised from debt and equity investors, and the debt is divided into a series of different levels, which we call tranches, from AAA, AA, single A, on down to BB or even single B.

The proceeds of the debt and equity issuance is used to purchase a portfolio of bank loans, and as that portfolio of floating rate bank loans generates coupon income, that income is taken on a quarterly basis and used to service the debt in order of priority. So the AAA investors get paid first, AA, single, on down. The residual, after fees and expenses of the vehicle, is paid out to equity investors as sort of a dividend, which is paid on a quarterly basis.

To the extent that there are losses in the bank loan portfolio, it works the opposite direction. The losses will hit the equity investment tranche first and move up from there. And it’s important to point out too that losses are measured on a realized basis. So to the extent that there are market value changes in the portfolio, the CLO, in many cases, really just tends to ignore that.

So, for the equity investor in a CLO, it’s sort of an arbitrage in the sense that on the day a CLO is issued, the debt spreads are effectively fixed for the life of the CLO.

Chart: The chart depicts a CLO equity arbitrage from portfolio income, cost of CLO debt, CLO fees, residual to equity and then the full equity tranche.

And as the portfolio generates coupon income, that’s used to service the debt. Now, to the extent that bank loan spreads increase, that portfolio of coupon income can increase as well. Since the debt costs are fixed, this can increase the amount that’s paid out to equity investors.

To the extent that the portfolio manager who is managing the bank loan portfolio is avoiding default and hopefully avoiding realized losses as well, a lot of those benefits of increasing spreads can actually flow through to the equity investors.

Chart: The bar chart (IRR) has a line graph overlay (year-end bank loan spreads) and looks at how CLO equity changes relative to widening bank spreads on an annual basis from 2003 to 2012.

And this is what we saw during the financial crisis and immediately after it, was that a lot of the CLOs that had been issued immediately before the financial crisis actually had very, very cheap borrowing costs. So as spreads subsequently widened over 2008, 2009, and stayed fairly wide in 2010, 2011, this actually increased the excess spread that was paid out to equity investors in the CLOs.

CLOs tend to get a bad rap from many investors because they are associated with the CDOs that were issued immediately before the financial crisis, many of which invested in residential mortgages or commercial mortgages or ABS, which actually didn’t do very well.

CLOs, by contrast, even though they were certainly marked down, and market values for CLOs fell, for investors who held on to those investments, they actually performed quite well.

So where we sit today, for many investors who look at credit spreads and may think that they are fully valued, now might actually not be a bad time to invest in CLOs or, in particular, CLO equity.

CLOs also generate fairly attractive income on a quarterly basis, so for investors who are perhaps waiting for a widening in credit spreads in the future, in many cases, they may be getting paid to wait.

Text on screen: Potential Risks of Investing in CLOs

  • Credit risk, including default
  • Prepayment risk
  • Illiquidity
  • Market volatility
  • Manager risk
  • Deterioration of collateral

For more insights and information, visit pimco.com

Filters: Reset All

Filters

Close Filters Dropdown

  • Tags

    Reset

    Close

  • Category

    Reset

    Bond by Bond
    Careers
    Economic and Market Commentary
    Investment Strategies
    PIMCO Foundation
    PIMCO Education
    View from the Investment Committee
    View From the Trade Floor
    Viewpoints
    Education
    Close

  • Order By

    Reset

    Alphabetical
    Most Recent
    Close
() filters applied

Multimedia Finder

Filter By:
  • Bond by Bond
  • Careers
  • Economic and Market Commentary
  • Investment Strategies
  • PIMCO Foundation
  • PIMCO Education
  • View from the Investment Committee
  • View From the Trade Floor
  • Viewpoints
  • Understanding Investing
  • A
  • B
  • C
  • D
  • E
  • F
  • G
  • H
  • I
  • K
  • M
  • N
  • P
  • Q
  • R
  • S
  • T
  • V
  • W
  • Y
  • Z
Clear
Berdibek Ahmedov
Product Strategist, Equities and Multi-Asset
Joshua Anderson
Portfolio Manager, Income and Asset-Backed Securities
Del Anderson
Credit Analyst
Robert Arnott
Founder and Chairman, Research Affiliates
Andrew Balls
CIO Global Fixed Income
Justin Blesy
Asset Allocation Strategist
Meredith Block
ESG Research Analyst
Adam Bowe
Portfolio Manager, Australia
Allison Boxer
Economist
David L. Braun
Portfolio Manager
Jelle Brons
Portfolio Manager, Global and U.S. Investment Grade Credit
Nathaniel Brown
Director of the PIMCO Foundation
Erin Browne
Portfolio Manager, Multi-Asset Strategies
Esteban Burbano
Fixed Income Strategist
Grover Burthey
Portfolio Manager, ESG
Libby Cantrill
U.S. Public Policy
Yishan Cao
Credit Research Analyst
Kenneth Chambers
Fixed Income Strategist
Stephen Chang
Portfolio Manager, Asia
Devin Chen
Portfolio Manager, Commercial Real Estate
Richard Clarida
Global Economic Advisor
Mathieu Clavel
Portfolio Manager, Alternative Credit
Tony Crescenzi
Portfolio Manager, Market Strategist
Josh Davis
Global Head of Risk Management
Pramol Dhawan
Portfolio Manager
Devin Ekberg
Senior Consultant, Advisor Education
David Erdonmez
Head of Research, Consultants and Product Group, Australia
David Fisher
Co-Head of Strategic Accounts, U.S. Global Wealth Management
David Forgash
Portfolio Manager
Preeyam Gandhi
Strategist
Max Gelb
Product Strategist
Nick Granger
Portfolio Manager, Quantitative Analytics
Adam Gubner
Portfolio Manager, Distressed Debt
Sachin Gupta
Portfolio Manager
Gregory Hall
Head of U.S. Global Wealth Management
Mary Hoppe
Account Manager
Ray Huang
Portfolio Manager, Real Estate
Daniel H. Hyman
Portfolio Manager
Daniel J. Ivascyn
Group Chief Investment Officer
Mark R. Kiesel
CIO Global Credit
Erica Kinsella
Product Strategist, ESG Strategies
Sean Klein
Head of Client Business Strategy – Client Solutions and Analytics
Kristofer Kraus
Portfolio Manager
Raji O. Manasseh
Equity Strategist
Jason Mandinach
Head of Alternative Credit and Private Strategies
Samuel Mary
ESG Research Analyst
Kyle McCarthy
Alternative Credit Strategist
Robert Mead
Head of Australia, Co-head of Asia-Pacific Portfolio Management
Mohit Mittal
Portfolio Manager, Multi-Sector
Alfred T. Murata
Portfolio Manager, Mortgage Credit
John Murray
Portfolio Manager, Global Private Real Estate
John Nersesian
Head of Advisor Education
Roger Nieves
Rick Pagnani
Head of Insurance-Linked Securities
Sonali Pier
Portfolio Manager, Multi-Sector Credit
Gavin Power
Chief of Sustainable Development and International Affairs
William Quinones
Product Strategist
Lupin Rahman
Portfolio Manager
Paul W. Reisz
Fixed Income Strategist
Graham A. Rennison
Quantitative Portfolio Manager
Libby Rodney
Steve A. Rodosky
Portfolio Manager
Emmanuel Roman
Chief Executive Officer
Steve Sapra
Senior Advisor
Jerome M. Schneider
Portfolio Manager
Marc P. Seidner
CIO Non-traditional Strategies
Emmanuel S. Sharef
Portfolio Manager, Asset Allocation and Multi Real Asset
Greg E. Sharenow
Portfolio Manager, Commodities and Real Assets
Candice Stack
Head of Client Management, Americas
Kimberley Stafford
Global Head of Product Strategy; Responsible for Sustainability Oversight
Cathy Stahl
Global Head of Marketing
Jason R. Steiner
Portfolio Manager, Private Lending and Opportunistic Strategies
Christian Stracke
President, Global Head of Credit Research
John Studzinski
Vice Chairman
Geraldine Sundstrom
Portfolio Manager, Asset Allocation, EMEA
Aaditya Thakur
Portfolio Manager, Australia and Global
Richard Thaler
Distinguished Service Professor of Economics and Behavioral Science at the University of Chicago's Booth School of Business
Jessica K. Tom
Senior Credit Analyst
François Trausch
CEO and CIO of PIMCO Prime Real Estate
Jerry Tsai
Client Solutions and Analytics
Matt Tuten
Portfolio Manager
John Valtwies
Account Manager, Global Wealth Management
Megan Walters
PIMCO Prime Real Estate
Qi Wang
CIO Portfolio Implementation
Taosha Wang
Jamie Weinstein
Portfolio Manager, Corporate Special Situations
Paul-James White
Portfolio Manager
Tiffany Wilding
Economist
Andrew T. Wittkop
Portfolio Manager, Treasuries, Agencies, Rates
Jerry Woytash
Portfolio Manager, Short-Term Desk
Nelson Yuan
Kirill Zavodov
Portfolio Manager
Mike Cudzil
Portfolio Manager
PIMCO
Ben Bernanke
Chair, Global Advisory Board
Seray Incoglu
Portfolio Manager, Commercial Real Estate
  • Alphabetical
  • Most Recent
Section : Date : Experts :
Reset All
Global Bonds: An Attractive Solution for Today’s Markets
Sustainable Development Goals at PIMCO
Forecast Favors Fixed Income
Positioning Portfolios for 2024
November 2023 Update from the Australia Trade Floor
Higher Yields Today Create Opportunity

Load more results Load {{cCtrl.fetchResults}} more results