CLOs vs. CDOs: Understanding the Difference

Today we're going to discuss the differences between collateralized loan obligations, or CLOs, versus collateralized debt obligations, or CDOs. This is probably one of the most common questions that we get from investors when we're talking about CLOs. And although these sound the same, a CLO should not be confused with a CDO. The two are fundamentally different.

What is a CLO?

A CLO is an actively managed securitized portfolio of leveraged loans. The CLO issues multiple tranches of debt with varying levels of seniority. You typically have a triple A tranche down to BB as well as a first loss tranche, which is also known as the equity tranche. The interest that's generated by the underlying loan portfolio, is used to pay interest on the CLO debt. And this structure resembles other types of securitizations as well.

A CDO, on the other hand, is more of a generic term for other types of securitized fixed income. So this could be high-yield bonds, credit default swaps, even other CDOs, and perhaps most infamously, subprime mortgages.

In both cases, the assets are securitized and the debt is backed by the underlying assets. That means that the risk return for investors is actually driven by the underlying collateral portfolio. There is an old saying, “garbage in, garbage out”, and that's especially relevant here because CDOs experienced extremely high losses in the years around and after the financial crisis. And as a result, many investors are wary of any form of structured credit. But CLOs actually had performance that held up very well and default rates remained extremely low. And this is because of what they hold as well as how they're structured.

Key Differences and Misconceptions

The main difference between a CLO and a CDO is the underlying collateral. The loans that CLOs hold are issued by banks to cash generating businesses through an underwriting process. These loans are senior to other forms of debt that the borrower may have and also secured by the borrower's assets. And this has driven loss rates that are historically lower on loans versus high yield bonds.

CLO portfolios are also transparent. You can see every loan in the portfolio. Typically, there's 200 to 300 loans in a CLO. And then a credit analyst can look at a CLO, look at the issuers, look at the sector exposure, and assess the level of risk that they're taking by investing in the CLO. I'd also note that because this is corporate credit, CLOs benefit from decades and decades of default and recovery data that can help form assumptions around how a CLO may perform in different market environments.

A CDO, on the other hand, is not transparent. And in the case of subprime mortgages, the underwriting standards that were used for many of these assets turned out to be very poor. And that resulted in a level of risk that was much higher than investors expected.

And unlike corporate credit, subprime mortgages were a relatively new market at the time of the GFC, and CDOs that held subprime mortgages were structured using assumptions that turned out to ultimately be incorrect.

Overall, investment-grade CLOs provide a very compelling combination of high quality as well as higher yield. And we believe they deserve a strategic allocation within a core bond portfolio.