CLOs: Expanding Access and Participation

The Evolving Landscape  

The CLO market has undergone a significant transformation in recent years. Initially, access was limited to institutional investors who had to navigate complex structures to participate. Since then, the asset class has grown not only in size but also in popularity, leading to heightened interest in collateralized loan obligations (CLOs). This rise in interest has resulted in the emergence of new products, increasing access and participation across the investor spectrum.  

The recent growth of closed-end funds, ETFs, and interval funds has increased accessibility to CLOs for both institutional and individual investors. This shift allows for greater flexibility, making it easier for investors to access CLOs without the lengthy lock-up periods typical of traditional hedge funds. Since 2022, the number of CLO ETFs has jumped from three to thirteen, with more sponsors preparing to enter the market.[i] This expansion not only enhances participation from managers and investors but also improves overall market liquidity.  

Same Pool, Your Choice of Risk 

The appeal of CLOs lies in the diverse ways investors can gain exposure to the same pool of loans. These loans are financed through various debt instruments, known as tranches, along with a subordinate note commonly referred to as CLO equity. The liquid CLO vehicles available in today’s market allow investors seeking flexibility to select from various exposure options, ranging from AAA-rated debt to equity. This also enables them to modify their CLO allocation to align with their most recent risk and return expectations.   

CLOs offer investors exposure to corporate loans through a structured approach that segments the financing of these loans. Classified as structured credit, CLOs consist of corporate loans funded by various tranches of debt and equity, creating a distinct capital structure with prioritized cash flows via a waterfall structure. Although all investors in the CLO are ultimately linked to the same underlying loan collateral, it is the financing structure that provides them with differentiated ways to access these loans, offering flexibility to align their exposure with their preferred level of risk.  

Capturing Spread  

The underlying value of the CLO is the spread generated between the income from the underlying pool of loans and the financing costs of the debt tranches. Since both the assets (loans) and liabilities (CLO debt) consist of floating rate instruments, the floating reference rate[ii] is largely neutralized.  If the CLO functions as intended, the various debt tranches will receive periodic income generated by the underlying loans. After meeting the debt obligations, the equity receives the residual cash flows, which can be substantial, even after the reduction management fees.  

Benefits & Risks 

CLOs offer a variety of benefits that cater to different investment objectives. Some of these benefits include: 

• Diversification: a diversified pool of senior secured loans with historically low default rates 

• Low Interest Rate Sensitivity: floating rate loans are less sensitive to changes in interest rates.  

• Attractive Yields: high yields relative to other assets, especially when adjusted for credit quality  

• Differentiated Risk Profile: lower duration risk relative to the higher duration risk of traditional bonds 

• Robust Risk Management: the underlying loan pool is actively managed by a collateral manager 

• Structural Protection: features like subordination that primarily benefit senior tranches, reducing potential loss given default 

Like all assets, CLOs carry risks that investors should understand. Although CLO strategies may exhibit lower volatility compared to other credit assets, they are vulnerable to significant drawdowns during periods of heightened risk. As credit assets, CLOs are susceptible to economic downturns. A rise in defaults could lead to failed tests intended to preserve the structure, diverting cash flows from lower -rated tranches to senior lenders. The level of risk varies across different parts of the capital structure, with lower-yielding senior tranches generally being safer while junior tranches carry more risk but with potentially higher returns.  

Compelling Opportunities 

While CLOs are not for everyone, the proliferation of new CLO products has significantly increased flexibility and liquidity for investors. Once dominated by institutional players, this asset class now offers individual investors access through innovative products. As CLOs gain more traction, their appeal for higher income and diversification benefits becomes evident. These vehicles enhance accessibility for a diverse range of investors, deepening the market and increasing its resilience, thereby positioning CLOs as a valuable component of the modern portfolio.   

Our experience in CLOs enables us to provide tailored exposures that meet our clients’ needs. We adopt a diversified approach to CLOs by allocating to multiple vehicles, giving our clients access to a broad range of managers, loan collateral, and tranches. CLO securities comprise various risk and return profiles; therefore, it is essential for investors to understand their risk tolerance and identify which part of the capital structure best aligns with their goals. Ultimately, the ideal way for investors to benefit from CLOs is by partnering with an experienced investor who can identify the right opportunities for them.