Collateralized Loan Obligations (CLOs) play an important role in credit markets by bridging the capital needs of corporate borrowers with the return objectives of institutional investors. At their core, these structured vehicles pool hundreds of senior secured loans and repackage them into tranches with varying levels of risk and return. Beyond their structure, CLOs serve two fundamental purposes: they provide efficient financing for companies and offer investors a diverse set of risk-adjusted return opportunities across the capital stack.

“A CLO functions like a mini closed-ended fund, where limited partner (LP) commitments are tranched into AAA- to B-rated securities,” explains Cathy Bevan, Head of Structured Credit and Portfolio Manager at Alcentra. “This structure imposes a strict priority of payments on both principal and interest cash flows generated by the underlying loan portfolio.” That portfolio typically comprises broadly syndicated loans, with average spreads of approximately 320 basis points in the U.S. and 390 in Europe, while the CLOs themselves carry a weighted average cost of capital of around 200 basis points.

“From an equity perspective, investors gain exposure to levered excess spread. From the debt side, CLO tranches offer attractive floating-rate income with built-in structural protections and asset subordination.”

“From an equity perspective, investors gain exposure to levered excess spread,” Bevan continues. “From the debt side, CLO tranches offer attractive floating-rate income with built-in structural protections and asset subordination.”

Tailored Risk and Return Profiles

The CLO structure allows investors to tailor their exposure based on risk appetite and return objectives. Senior tranches offer strong credit protection and stable income, while junior and equity tranches provide higher return potential in exchange for higher risk. “AAA tranches are very remote from risk and are currently trading at base rates [SOFR/EUR] plus 140 basis points – still very attractive, though spreads are tightening,” notes Bevan. “BB tranches, by contrast, are trading around base rates plus 550 to 600 basis points. That’s compelling relative to leveraged loans and high yield, especially given the structural benefit of asset subordination, which shields them from the first losses in the portfolio.”

CLO equity in both the U.S. and Europe is currently trading at an internal rate of return (IRR) of around 13 percent, roughly in line with the yields on European single-B tranches, which offer base rates [SOFR/EUR] plus 900 basis points. Given that CLO equity is more directly exposed to default risk in the underlying loan portfolio, the team at Alcentra currently favors single-B tranches over equity. However, “CLO Equity is in demand at the moment because investors are seeking assets with high cash flow. CLO equity offers this, due to the leveraged interest income,” explains Bevan.

The bulk of the CLO equity return is driven by the excess interest earned on the underlying loans compared to the interest paid out on the CLO’s debt. “Because CLOs employ leverage, that difference – or “excess spread” – gets amplified, generating the majority of the equity returns,” she elaborates. “That cash yield is a key reason why many investors are being drawn to the CLO equity.”

“Because CLOs employ leverage, that difference – or “excess spread” – gets amplified, generating the majority of the equity returns.”

A less discussed risk is the mismatch in non-call periods between the underlying assets and the liabilities. “Underlying loans typically have a non-call period of around six months, while CLO liabilities are often non-callable for 1.5 to 2 years,” explains Bevan. When loan spreads tighten, the loan portfolio can be refinanced quickly, which compresses the excess spread and reduces equity returns – yet the liability costs remain fixed, at least until the expiry of the non-call period. “This erosion of the interest rate arbitrage is a unique risk to CLO equity that many fail to fully account for,” says Bevan. 

For this reason, Alcentra tends to favor purchasing CLO equity in the secondary market. “This strategy often provides more attractive risk-adjusted opportunities compared to investing in primary issuance during tight-spread environments.”

Structural Protection and Volatility as Opportunity

Collateralized Loan Obligation (CLO) debt tranches offer a compelling mix of solid returns and structural credit protection. However, this comes with trade-offs: CLO tranches are more sensitive to market sentiment, exhibiting greater mark-to-market volatility and less liquidity during periods of stress. “Sub-IG CLO tranches offer higher returns than loans or high yield, with the added benefit of first-loss protection,” confirms Bevan. “But when markets widen, CLO tranche discount margins tend to widen even more.”

The longer credit spread duration of CLO debt tranches – relative to broadly syndicated loans – also contributes to their greater price sensitivity. While CLO tranches tend to experience sharper spread widening than loans or high-yield bonds during periods of market dislocation, this volatility can be advantageous, creating attractive entry points. “CLO debt tranches offer better risk-adjusted returns than loans or direct lending from a fundamental standpoint, despite exhibiting higher mark-to-market volatility,” considers Bevan. “We view that volatility as an opportunity, and generally recommend maintaining a core allocation to CLO tranches with the flexibility to increase exposure in times of market dislocation or investing through closed-end vehicles with the ability to draw capital to allocate opportunistically.”

“CLO debt tranches offer better risk-adjusted returns than loans or direct lending from a fundamental standpoint, despite exhibiting higher mark-to-market volatility. We view that volatility as an opportunity…”

While CLO debt tranches are less liquid than broadly syndicated loans or high-yield bonds, they remain relatively tradeable. Dealers often hold inventory and support two-way markets, but a significant proportion of trading volumes occur via bond auctions called “BWICs” (Bids Wanted in Competition). “Given that each CLO is usually around $400–$500 million in total size, you’re unlikely to see observable two-way quotes across a large portion of your CLO tranche portfolio at any given time,” notes Bevan. Still, for allocators who can tolerate some liquidity constraints, CLO tranches offer a compelling long-term return profile, underpinned by strong structural protections and resilient credit fundamentals – making them a valuable component of a diversified income strategy.

Manager Selection: A Crucial Determinant of Returns

When investing in CLOs – especially in mezzanine and equity tranches – choosing the right manager is absolutely critical. “We observe significant dispersion in manager performance, particularly in the US, and this variation becomes increasingly impactful deeper down the CLO capital structure,” notes Bevan. However, she cautions that the label “top-tier” can be misleading; reputation and brand recognition do not always translate into strong performance. Instead, the Alcentra team takes a rigorous approach, “looking through to the underlying credit risk in each portfolio based on our own independent views – not relying solely on rating agency assessments – and evaluating managers accordingly.”

“We observe significant dispersion in manager performance, particularly in the US, and this variation becomes increasingly impactful deeper down the CLO capital structure.”

Assessing a manager’s true quality demands a deeper dive into their credit selection, portfolio construction, and skill in navigating the intricate structural dynamics of a CLO. “Some managers are better at portfolio construction and managing the CLO structure better,” explains Bevan. “Because of the leverage inherent in CLO equity, the portfolio should differ significantly from a typical high-yield or loan fund. Position sizing is crucial, as one large misstep in an overweight name can materially affect the CLO equity’s performance.”

Regional Market Divergence

The European CLO market has been growing at a faster pace than its U.S. counterpart, but the demand for CLO tranches hasn’t expanded at the same rate. “This imbalance creates attractive opportunities for investors like us to buy CLO debt tranches at attractive levels,” notes Bevan. Meanwhile, underlying loan markets in both the U.S. and Europe have experienced limited growth, which in turn pressures the traditional CLO equity arbitrage – the excess interest income generated through leverage. “That dynamic is putting strain on the new issue CLO equity arb, which is why we currently have a preference for single Bs over equity,” she adds.

“This imbalance creates attractive opportunities for investors like us to buy CLO debt tranches at attractive levels.”

Ultimately, CLOs remain a powerful vehicle for accessing diverse credit exposures with tailored risk and return characteristics. Structural protections, enhanced cash yields, and opportunities from market dislocations make them an attractive option for institutional allocators – provided investors apply rigorous manager due diligence.

Views expressed are those of Alcentra as of the date of this article and are subject to change.

This article features in the “2025 Private Markets” publication.