Five reasons to invest in CLOs

Collateralised loan obligations (CLOs) are securitisations backed by a large pool of senior secured corporate loans, which are financed partly via selling bonds to investors.

The repayments on the loan pool generate income for the CLO bonds, which are issued in tranches carrying different credit ratings and yields based on their seniority and level of risk.

The key difference between most CLOs and other securitisations such as mortgage-backed securities is that the loan pool is actively managed by a CLO manager. The CLO manager builds a diversified portfolio of loans made to companies of different sizes across multiple industries and geographies, and can add or remove loans during the investment period to try to optimise returns for the CLO.

At $1.1tr outstanding in the US and €300bn ($349bn) in Europe ¹, CLOs make up a sizeable proportion of the global asset-backed securities (ABS) market, and for fixed income investors they have several potentially attractive features.

With regulatory changes in Europe set to markedly reduce the capital charges on CLOs in early 2027, demand for the asset class is likely to increase.

Here are five potential advantages of CLOs.

1.  Yield premium

CLOs typically offer higher yields than comparably rated corporate bonds. While this CLO premium varies over time (see Exhibit 1), in general, AAA rated CLO bonds have historically offered broadly similar yields to BBB rated corporate bonds, while BB rated CLO bonds have regularly offered over 300 basis points (bp) more yield than high yield (HY) corporate bonds.

One of the drivers of this yield premium is the specialism of the asset class, as opposed to a reflection of weaker underlying credit quality. With considerable expertise and resources required to analyse CLO structures and perform due diligence on the underlying corporate loans, this can create an opportunity for active asset managers to capture the CLO premium and target excess returns.

2.  Floating rate protection

Most CLO bonds are issued in floating rate format, where coupons adjust in line with interest rates. This means CLOs carry minimal duration risk, which can help to hedge a portfolio against inflation or shifting market expectations around central bank policy. 

Importantly, CLOs also have built-in interest rate “floors” to prevent their yield from disappearing if base rates drop significantly. As a result, CLOs investors may benefit from rising rates while having some mitigation against the downside.

As Exhibit 2 shows, the floating rate structure of CLO bonds allows for a natural rise in yields when benchmark interest rates rise.

3.  Diversification

Historically, CLOs have demonstrated a low correlation with more mainstream bond markets such as investment grade (IG) corporates and US Treasuries, making the asset class an effective diversifier for broader fixed income holdings.

CLO loan pools themselves are granular and generally well diversified by industry, geography and sector, which helps to mitigate underlying credit risk. A typical US CLO pool holds 300-400 loans, for example, while a typical European CLO holds 150-200. Market standard concentration limits also restrict maximum exposure to a single borrower to 2.50% in Europe and 2.00% in the US, limiting the impact of a single loan’s performance on the overall pool and helping to reduce idiosyncratic credit risk.

A global approach to CLOs can potentially enhance this diversification benefit, given there are meaningful differences in subordination levels, regulation, CLO manager styles and sector exposures (see Exhibit 3) between the US and European markets.

4.  Downside mitigation for bondholders

CLOs have certain structural features which are intended to cushion investors’ coupon and principal payments against the risk of potential losses on the underlying assets.
The first of these is subordination. If the loans in the CLO pool pay interest and principal as expected, this pays interest and principal on the bonds in order of seniority, from the AAA notes at the top through to the equity tranche at the bottom – often referred to as a “waterfall” structure. If, however, the performance of the loan pool deteriorates sufficiently to impact these cashflows, the more senior bondholders benefit from subordination as the more junior tranches, starting with equity and moving upward, absorb losses first (see Exhibit 4).

This subordination, which in the market is also referred to as “credit protection,” can provide a cushion against losses. For example, on average the BB tranche in a European CLO has around 9.5% of subordination; for BB bondholders to suffer their first euro of principal loss, the default rate on the loan pool would have to reach around 30% (assuming a 70% recovery rate). For AAA notes, this credit protection increases to around 40%, which means the default rate on the loan pool would need to reach over 90% (again assuming a 70% recovery rate) before the typical AAA tranche would suffer the first euro of principal loss.

Further risk mitigation for bondholders comes in the form of credit enhancement, which refers to techniques used by CLO managers to improve the creditworthiness of the debt tranches of CLOs. These include overcollateralisation (ensuring the principal value of the underlying loans exceeds that of the CLO’s debt) and cash reserve funds, whereby a predetermined proportion of cashflows is held back to make up any shortfall in coupon payments that might occur because of unexpected portfolio losses.

To further mitigate underlying credit risk, CLO managers make binding commitments on how they will build and manage the asset pool. Limits are set on exposure to lower rated loans or exposure to certain industries, for example, while collateral quality tests establish minimum levels for metrics such as overcollateralisation and interest coverage ratios. Importantly, these commitments can vary, so scrutinising the terms of each deal and the general approach of each CLO manager can be essential.

5.  A track record of low default rates 

CLO credit performance has been resilient over the longer term. Globally there hasn’t been a single AAA CLO default in the last 25 years, according to ratings agency S&P, a period that covers both the global financial crisis and the Covid-19 pandemic. ²  Further down the capital stack, CLOs have historically experienced lower defaults and losses than both IG and HY corporate bonds with comparable credit ratings (see Exhibit 5). 

This track record is partly driven by the senior secured structure of the loans in a CLO. These loans still carry default risk, but their seniority in the corporate creditor hierarchy means they tend to produce higher recovery rates than vanilla corporate bonds in the event of default. CLOs’ historical credit performance is also supported by other downside mitigation features such as the overcollateralisation tests described above, which ensure that CLO cashflows are directed to senior tranches if the value of the loan pool falls below a predetermined level.

Why TwentyFour?    

The potential advantages of investing in CLOs are clear, but we believe capturing them successfully while managing market risks requires specialist active management.  At TwentyFour, CLOs are a core part of our ABS business, with the $3.7bn we had invested in the asset class across our strategies as of May 2026 representing around 15% of the firm’s total holdings. 

In London, we have a 10-person ABS and CLO investment team that combines deep securitisation expertise with extensive due diligence on the risks of the underlying assets. This gives us a clear view on CLO issuers’ management teams, approaches to risk management, culture, and market position.

The TwentyFour team is highly selective and uses a relative value approach, seeking attractive risk-adjusted opportunities across the capital stack in both the US and Europe. We also have longstanding relationships with major CLO managers, which can be important for accessing new deals in a market driven by primary issuance. We believe this combination leaves TwentyFour well placed to capture market opportunities.