The author of this article takes a dive into the world of what are called collateralized loan obligations. There are risks – which is why diversification and close management are important elements. The author explains how this works.

Collateralized loan obligations (CLOs) have long been a feature of the investment landscape – dating back to the 1990s – however investors have been increasingly drawn to them of late for their combination of diversification, income generation and equity-like return potential. 

CLOs are structured products made up of leveraged loans, with equity tranches sitting at the bottom of the capital stack. The equity returns can be often 500, 600, or even 700 basis points above interbank rates – over a typical six-to-10-year lifecycle.

In an interview with Family Wealth Report, Alan Strauss (pictured below), senior partner and director of investor relations at Crystal Capital Partners, a turn-key alternative investment platform, explained why CLO equity, in particular, continues to stand out.

Alan Strauss

“This is an attractive asset class, but the key is diversification,” Strauss noted. “CLOs are like hybrids,” he added. “They can provide equity-like returns and also income, making them an all-weather allocation rather than an opportunistic play.” Strauss also emphasized that manager skill is critical to outcomes. Most CLOs are closed-ended structures, and Crystal has built a platform for advisors to construct tailored portfolios of alternative investment products, which may include CLOs. In exchange for providing this service, Crystal charges a management fee.

Education is central to this process: “Knowledge is power and you have to lead with education,” Strauss said. With private wealth managers increasingly integrating alternative credit strategies into client portfolios as a complement to traditional fixed income exposures, Strauss sees “extreme interest and substantial demand” for this asset class.

As advisors seek out differentiated sources of income beyond traditional fixed income, collateralized loan obligation (CLO) equity is emerging as an overlooked source of potential double-digit returns for income-seeking investors, Strauss said.

In 2024, the US CLO market hit a record $202 billion in new issue volumes priced, according to Flow, Deutsche Bank’s magazine (1). This momentum isn’t slowing – BMO Global Asset Management, citing JP Morgan data, projects that the market will grow by a third, surpassing $2 trillion by 2027 (2). Yet, within this expanding market, it is the equity tranche – the first to absorb losses, but the last to get paid – that offers the highest risk-adjusted upside when managed properly. 

CLOs are structured securities backed primarily by pools of senior secured leveraged loans. Originally launched in the 1990s to help banks offload balance sheet risk, CLOs have since evolved, drawing in investors seeking higher yields. Interest surged in the mid-2000s but stalled during the 2008 financial crisis, prompting reforms that improved the asset class’s structure. Still, equity tranches remain underutilized in financial advisor portfolios, given that they are often misunderstood or dismissed as too complex and risky for client portfolios, Strauss argued.

Much of this caution overlooks how far CLOs have evolved. CLOs’ sensitivity to credit cycles remains a valid concern, Strauss continued.

"If defaults rise within the underlying loan pool, cash flows to junior tranches, particularly equity holders, can be reduced or suspended. Recent headlines, for example, Janus Henderson’s CLO ETF experiencing an outflow of $600 million have also contributed to this trepidation (3)," he said.   

However, CLO equity also benefits from structural safeguards and a dynamic feedback loop that can favor long-term investors, he said. CLOs include mechanisms that push managers to lend more conservatively or halt new loan activity when funding costs rise. Regulatory reforms like the Dodd-Frank Act and Volcker Rule have contributed to improved CLO transparency and risk management. Additionally, a new feature, Applicable Margin Reset (AMR), though not yet widespread, allows interest rates on CLO liabilities to reset via auction. While this primarily impacts debt tranches, it can improve residual cash flows available to equity holders by lowering the overall cost of capital. 

Understanding the “waterfall” cash flow structure is crucial. CLOs distribute income from loan repayments through tranches. Senior tranches receive priority payments and offer lower returns; equity tranches are paid last and carry the most risk, but with the potential for returns in the mid-to-high teens, especially in stable or improving credit markets. According to PineBridge Investments, citing JP Morgan, Bloomberg and LCD data, even lower-rated CLO tranches have outperformed high-yield and investment-grade bonds (4). Well-selected CLO equity can outperform both, though returns vary significantly depending on the manager’s skill and market cycle positioning, Strauss said. 

"What truly differentiates CLO equity from other alternative income strategies is the value of manager selection. Advisors must evaluate several key factors: portfolio diversification, manager experience, active versus passive management and, importantly, recovery assumptions. CLOs typically offer higher yields due to their complexity and limited accessibility, so a manager’s advantage is their knowledge of the market," he said. "Advisors should choose a manager with a track record of performing over cycles and proven loan origination discipline. Equity tranches especially benefit from active management, where managers can opportunistically reinvest cash flows or buy discounted loans during market volatility, capturing upside others miss."

Performance dispersion is significant in CLO equity. A manager assuming 80 per cent recovery on defaulted loans will take vastly different portfolio actions than one assuming only 5 per cent. These differences can have an outsized impact on returns for equity holders, where every basis point of spread matters. For advisors, evaluating these assumptions, and not just headline performance, can be the key to unlocking alpha in client portfolios, he said. 

Strauss concluded: "In sum, CLO equity offers a compelling, if complex, opportunity for financial advisors seeking differentiated yield in a relatively insulated structure. While inherent risks like collateral deterioration, defaults and prepayments cannot be ignored, they can be actively mitigated through structure, regulation and experienced management. For clients comfortable with complexity and volatility, CLO equity provides a differentiated alternative income stream, with the potential to significantly enhance portfolio returns when approached thoughtfully."

Footnotes

1  flow. Feb. 11, 2025. Outlook for CLOs in 2025 – reason for optimism? https://flow.db.com/trust-and-agency-services/outlook-for-clos-in-2025-reason-for-optimism
2  Jarosz, Mark. BMO Global Asset Management. Apr. 29, 2025. Inside the cash flow waterfall: A brief introduction to CLOs. https://bmogam.com/ca-en/insights/inside-the-cash-flow-waterfall-a-brief-introduction-to-clos/ 
3  Greifeld, Katie. Bloomberg. Apr. 8, 2025. Cracks Are Forming in CLO Market as ETFs on Record Selling Spree. https://www.bloomberg.com/news/articles/2025-04-08/cracks-are-forming-in-clo-market-as-etfs-on-record-selling-spree 
4  Kollmorgen, Laila. PineBridge Investments. Dec. 11, 2024. CLOs: Benefits and Risks. https://www.pinebridge.com/en/insights/clos-benefits-and-risks