CLOs Explained: Collateralised Loan Obligations

CLOs

A CLO pools leveraged loans and splits the cash flows into tranches from AAA to equity. Learn how CLOs work, the waterfall, coverage tests and the risks.

Advanced3 min readUpdated 3 Oct 2026

Lesson 19 of 20

A collateralised loan obligation (CLO) is a securitisation that buys a diversified pool of leveraged loans, which are floating rate loans to companies with below investment grade ratings, and funds that purchase by issuing notes in several tranches with different levels of risk. Senior tranches are rated AAA and get paid first; junior tranches and equity absorb losses first in exchange for higher returns. CLOs are a major source of financing for leveraged companies and a large part of the credit market, with roughly $1 trillion outstanding in the US.

How a CLO is built#

A CLO manager raises capital by issuing notes and equity.
It buys a portfolio of around 150 to 300 leveraged loans across many industries.
Loan interest and principal flow into the CLO.
Cash is paid out to tranches in order of seniority, the "waterfall".
The manager actively trades loans during a reinvestment period, typically four to five years.

The capital structure#

Tranche	Approximate share	Typical rating	Paid	Losses absorbed
AAA	About 60% to 65%	AAA	First	Last
AA	About 10%	AA	Second
A	About 6%	A
BBB	About 6%	BBB
BB	About 5%	BB
Equity	About 8% to 10%	Unrated	Last (residual cash)	First

Approximate typical structure; actual deals vary.

The waterfall and coverage tests#

Interest from the loans pays senior tranches first, then mezzanine, then equity. CLOs include overcollateralisation (OC) and interest coverage (IC) tests. If loan defaults or downgrades cause these tests to fail, cash that would go to junior tranches and equity is diverted to pay down senior notes, protecting senior investors.

Why investors buy CLOs#

Floating rate coupons: income rises with interest rates.
Higher spreads than similarly rated corporate bonds, partly for complexity and liquidity.
Track record: CLO AAA tranches have experienced no defaults in their history, and losses on CLO debt overall were very low through 2008 and 2020, according to rating agency data.
Equity returns: CLO equity offers leveraged exposure to loan spreads and active management.

CLOs vs CDOs from 2008#

	CLOs	Mortgage CDOs (2000s)
Collateral	Diversified corporate loans	Subprime mortgage securities, often other CDO tranches
Management	Active managers	Often static
Performance in 2008	Senior tranches held up	Huge losses even on AAA tranches
Correlation	Diversified across industries	Highly correlated housing exposure

The CDO failures in 2008 were driven by concentrated, correlated mortgage exposure and poor ratings. CLOs have a different structure and record, but they still depend on corporate credit cycles. See The 2008 Financial Crisis and Credit Ratings.

Risks#

Credit risk in the underlying loans, especially in recessions.
Covenant lite loans: weaker lender protections can lower recoveries.
Downgrades of loans to CCC can trigger coverage test failures.
Liquidity: junior tranches and equity trade infrequently.
Manager risk: performance varies by manager.
Complexity of documentation and models.

Frequently asked questions#

What is a CLO?#

A securitisation that pools leveraged corporate loans and issues tranches of debt and equity with different levels of risk and return.

Are CLOs risky?#

Senior tranches have had very low losses historically, while junior tranches and equity carry significant risk, especially in recessions.

How are CLOs different from the CDOs of 2008?#

CLOs hold diversified, actively managed corporate loans, while many 2008 CDOs held concentrated, correlated mortgage exposure and suffered large losses.

Next, learn how investors trade broad credit risk in Credit Indices.

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Next lessonCredit IndicesCredit indices track baskets of credit default swaps or bonds. Learn how CDX and iTraxx work, rolls, index tranches, bond indices and how traders use them.