# 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.

Source: https://learn.tradelabsai.com/bonds-credit/clos/  
Track: Bonds, Rates and Credit · Level: Advanced · Updated: 2026-10-03  
Publisher: TradeLabs AI (https://tradelabsai.com). Education, not financial advice.  
Cite as: TradeLabs Learn, "CLOs", https://learn.tradelabsai.com/bonds-credit/clos/

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

1. **A CLO manager raises capital** by issuing notes and equity.
2. **It buys a portfolio** of around 150 to 300 leveraged loans across many industries.
3. **Loan interest and principal** flow into the CLO.
4. **Cash is paid out** to tranches in order of seniority, the "waterfall".
5. **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.

**Example: How losses flow**
A $500 million CLO has $40 million of equity beneath its debt tranches. Over two years, loans with $50 million of par default, recovering 60%. The loss is $20 million (40% of $50 million). The equity absorbs it fully, falling from $40 million to $20 million in par terms; all debt tranches remain whole. If losses kept growing past the equity, the BB tranche would be hit next, then BBB, and so on. Coverage tests would also redirect cash to protect senior holders.

## 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](https://learn.tradelabsai.com/history/the-2008-financial-crisis/) and [Credit Ratings](https://learn.tradelabsai.com/bonds-credit/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](https://learn.tradelabsai.com/bonds-credit/credit-indices/).

## Continue learning

- Next lesson: [Credit Indices](https://learn.tradelabsai.com/bonds-credit/credit-indices/)
- Previous lesson: [Distressed Debt and Bankruptcy Trading](https://learn.tradelabsai.com/bonds-credit/distressed-debt/)
- Related: [Distressed Debt and Bankruptcy Trading](https://learn.tradelabsai.com/bonds-credit/distressed-debt/): Distressed debt is the bonds and loans of companies near default, bought at deep discounts. Learn how investors value it, the bankruptcy process and strategies.
- Related: [Default Probability and Recovery Rate](https://learn.tradelabsai.com/bonds-credit/default-probability/): Default probability is the chance a borrower fails to pay. Learn historical default rates, probabilities implied by spreads, the Merton model and recovery rates.
- Related: [Credit Ratings](https://learn.tradelabsai.com/bonds-credit/credit-ratings/): Credit ratings from S&P, Moody's and Fitch grade the risk of default on bonds. Learn the scales, investment grade vs high yield, default rates by rating and limits.
- Related: [Investment Grade vs High-Yield Bonds](https://learn.tradelabsai.com/bonds-credit/high-yield-bonds/): High yield bonds are rated below investment grade and pay higher interest for higher default risk. Learn how they behave, default cycles, spreads and how to invest.
- Related: [The 2008 Financial Crisis](https://learn.tradelabsai.com/history/the-2008-financial-crisis/): The 2008 financial crisis grew from a US housing bubble into a global banking panic. Learn the causes, the collapse of Lehman Brothers, the response and the lessons.
- Related: [Credit Spreads](https://learn.tradelabsai.com/bonds-credit/credit-spreads/): A credit spread is the extra yield a risky bond pays over a safe benchmark. Learn how spreads are measured, what drives them and what they signal about risk.