Demystifying Collateralized Loan Obligations (CLOs)

Key takeaways

• CLOs are a segment of securitized fixed income markets which can offer investors varying levels of income and risk, depending on the securities they choose.
• Today, more investors are allocating to CLOs as their floating rate coupons can offer potential protection from interest rate volatility, as well as higher yields compared to similarly rated corporate debt.
• Due to CLOs’ unique characteristics, an experienced portfolio management team may be beneficial to leverage when choosing to invest in this asset class.
• ETFs can offer an efficient way to access CLOs, whether it be through a multi-sector strategy or through CLO-focused ETFs.

The CLO market has grown steadily over the last few years, ¹ yet historically, direct investor participation in this market was primarily restricted to institutional and qualified investors. However, this landscape changed with the introduction of CLO-specific exchange-traded funds (ETFs), which provided a broader investor base with access to the potential benefits of this asset class. Likely as a result of this increased accessibility, there has been a surge in interest from investors seeking to understand the intricacies of CLOs and how to effectively incorporate them into diversified investment portfolios. Ultimately, the introduction of CLO ETFs has democratized access to this asset class, allowing more individuals and institutions to invest in these securities through the efficiency of the ETF wrapper.

Today, CLOs are no longer considered a “niche” market, having matured to a $1.2tn market globally, in line with the size of the $1.4tn US High Yield bond market.² As a result, just as investors may allocate a portion of their portfolios to other non-core sectors, CLOs are becoming more of a “core” part of today’s expanded fixed income toolkit.

What are CLOs?

A CLO is an investment vehicle that owns below investment grade, floating rate loans - just like those held in bank loan funds. What differentiates an investment in a CLO from a bank loan fund is the investor’s exposure to adverse credit events (e.g. defaults) in the pool of loans. In a bank loan fund, all investors have the same exposure to credit events. In a CLO, exposure to credit events depends on where in the CLO capital structure an investor chooses to be, ranging from highly rated (e.g, AAA-rated exposures) securities to lower rated – yet higher yielding ones (e.g., BBB-rated and below).

The varying risk exposures within a CLO stem from its capitalization structure. To acquire the loans, the CLO issues securities, known as tranches, each offering different levels of exposure to the underlying loan risks as seen in Figure 1.

The lowest-risk tranche is typically rated AAA by one of the major credit rating agencies, and is often referred to as the 'senior' tranche. The tranches positioned below that are then categorized as 'mezzanine' tranches (and tend to receive a lower rating, ranging from AA to B). The lowest and riskiest tranche is referred to as the equity tranche, which bears the first losses if defaults or other adverse events occur in the loan pool. These equity tranches are not assigned credit ratings due to their higher risk profile.

In terms of expected returns, the equity tranche offers the highest potential return, reflecting its higher risk. The senior tranche, conversely, has a lower expected return but carries the least risk. The mezzanine tranches fall between these extremes, offering a balance of risk and return.

Figure 1: The structure of a CLO

The process of creating a CLO and issuing tranches to finance the acquisition of the underlying loans is known as securitization. This process is prevalent in fixed-income markets; importantly, though, not all securitized markets share the same characteristics. For example, although CLOs and collateralized debt obligations (CDOs) may sound similar, they differ significantly in several key aspect such as their underlying assets, the diversification of their loan pools, structural features designed to help protect investors, and the active management of the loan pools. Moreover, CLOs have a distinct history compared to CDOs, particularly in the context of the Global Financial Crisis (GFC) where CLOs experienced only minimal losses.³

Notably, no AAA-rated CLO has ever defaulted.³ Default rates in mezzanine CLO tranches are also significantly lower than those seen in similarly rated corporate bonds. In fact, in typical CLO structures, more than half of the underlying loans would need to default before the AAA-rated tranche begins to incur losses.⁴ While lower-rated tranches may experience losses earlier, the loss thresholds required to trigger default are typically higher than those encountered during most market cycles, offering an added layer of protection for investors in the senior tranches.

Figure 2: S&P 10-year cumulative default rates (%)

The risks and rewards of investing in CLOs

Given the complexity involved in understanding the structure of each CLO and the specialized expertise required to evaluate them, coupled with their historically limited investor base, CLOs have historically offered higher yields compared to similarly rated corporate debt. As of 1/31/2025, AAA CLOs yielded (yield to maturity) 5.4%, in-line with the 5.3% for Investment Grade (IG) corporates at a higher credit quality (the index average rating is A-/BBB+); BBB CLOs yielded 7.5% vs. 5.5% for BBB-rated corporates and 7.2% for the below investment grade (high yield) corporate market.⁵ CLOs are floating-rate securities, meaning their coupon payments adjust periodically based on changes in short-term interest rates. If interest rates rise, the coupon payments on CLOs could be reset to higher rates, benefiting investors by providing greater income in a rising-rate environment. This inherent feature of floating rates offers a potential level of risk mitigation for investors, particularly in the context of today’s elevated interest rate volatility, as it allows CLOs to better align with prevailing market conditions and help mitigate the impact of interest rate fluctuations on returns.

In addition to higher yields, CLOs have also historically exhibited lower volatility and have realized lower drawdowns in market stress. In the last ten years, AAA CLOs realized a volatility of 1.9% while IG corporates realized volatility of 6.0%. As mentioned above, no AAA-rated CLO has ever defaulted in the history of the asset class. The comparison is closer in BBB-rated CLOs, which realized a volatility of 6.5% vs. 6.0% for BBB-rated corporates.⁶

So, what’s the catch? While they generally exhibit low credit risk due to the structure of the underlying loans, CLO spreads can still widen during periods of broader market volatility, changes in asset allocations by large institutional investors, or shifts in investor sentiment. These factors can cause price declines and negatively impact performance, even if the credit quality of the underlying loans remains stable. The largest drawdown experienced by AAA CLOs in the last 10 years was in March 2020 and was -10% using daily returns and -5% using monthly returns, in line with shorter duration markets and smaller than other fixed income sectors.⁶ BBB CLOs saw more downside over the pandemic, experiencing a 30% drawdown, in-excess of the 16% max drawdown experienced by BBB corporates and the 20% drawdown of high yield corporates.⁶

Figure 3: Attractive yields relative to historic drawdowns

The importance of an experienced PM team

CLOs can differ from traditional fixed-income securities in several key aspects, including their risks, liquidity, trading characteristics, and the types of investors involved. As such, investing in CLOs requires a sophisticated and knowledgeable portfolio management team to help navigate these complexities effectively. BlackRock stands as one of the largest asset managers in the CLO market, managing $33 billion in CLO tranches through a dedicated CLO team.⁷

Additionally, BlackRock oversees a $30 billion corporate loan investment team, which provides deep expertise in evaluating the underlying collateral of each CLO.⁸ We believe our team’s advantage is a rigorous investment process, developed over years of experience which includes a comprehensive evaluation of CLO structures and the underlying collateral characteristics. This process is further enhanced by our ability to identify relative value opportunities, a key benefit of being part of a large fixed income platform. Our deep expertise and extensive resources enable us to aim to navigate the complexities of the CLO market effectively, ultimately seeking to provide our clients with informed, strategic investment solutions.

CLO ETFs and how to invest in CLOs today

Given their relatively high yields today, attractive spreads relative to other credit sectors, lack of duration risk, and historically low volatility, we see both a strategic and tactical reason to consider owning CLOs today.⁹ Within BlackRock, we are allocating to this sector across a wide variety of active multi-sector strategies from the iShares Flexible Income Active ETF fund to the iShares Short Duration Bond Active ETF. Additionally, investors are able to utilize standalone CLO ETFs, including the iShares AAA CLO Active ETF and the iShares BBB-BB CLO Active ETF to access this market themselves. In fact, CLO ETFs have grown to be a $23bn market, impressive given they did not exist just a few years ago.¹⁰

Ultimately, BlackRock and our clients can utilize CLOs across a spectrum of use cases, from diversifying their income portfolios and capital preservation allocations, to provide a hedge against interest rate volatility. Whether it is a first-time allocation to this asset class, or the strategic use of a daily liquidity vehicle with low investment minimums, the ETF wrapper has helped expand access to CLOs and all their potential benefits.

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