Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds, Loans, and Derivatives

CHAPTER 4

Collateralized Loan Obligations

Collateralized loan obligations (CLOs) have been around for more than 20 years and until September 2007 purchased two-thirds of all U.S. leveraged loans. A CLO issues debt and equity and uses the funds it raises to invest in a portfolio of leveraged loans. It distributes the cash flows from its asset portfolio to the holders of its various liabilities in prescribed ways that take into account the relative seniority of those liabilities. We will fill in this definition over the next few pages, and rest assured, we do not take anything for granted.

To properly explain CLOs, we break them down into their four moving parts: assets, liabilities, purposes, and credit structures. We explain each building block in detail and create a framework for understanding CLOs that puts old and new CLO variants in context. Next, we define the roles of the different parties to a CLO. This will conclude our initial pass at CLOs. We then circle back, emphasizing particular topics of importance to CLO investors: the cash flow credit structure, the advantages of CLO equity, and how CLO equity fits into an existing portfolio.

UNDERSTANDING CLOs

A CLO can be well described by focusing on its four important attributes: assets, liabilities, purposes, and credit structures. Like any company, a CLO has assets. With a CLO, these are corporate loans, most always leveraged loans rated speculative grade. And like any company, a CLO has liabilities. With a CLO, these ...