Why advisors might consider CLOs

As chief investment officer at Flat Rock Global, Shiloh Bates believes in the private credit story.

After all, there are several different ways to get exposure to the asset class.

One of the ways to get such exposure is by using Collateralized Loan Obligations (CLOs), which he said can be a powerful tool for advisors to differentiate their offerings and provide unique value to clients.

These floating-rate instruments have seen an impressive year, surging in popularity and hitting record levels in 2024.

"A typical CLO today might have $500 million in assets, comprised of first lien, senior secured loans and float based on secured overnight financing rate (SOFR),” Bates said.

These loans are created through leveraged buyouts, where private equity firms finance a portion of the purchase price with term loans that are then split among multiple CLOs.

“CLOs are a pure-play lending vehicle,” Bates said. Unlike large commercial banks that operate across numerous business lines, “CLOs function like an old-school bank,” making their simplicity and focused strategy a key part of their appeal.

CLOs finance their portfolios by issuing securities in tranches, ranging from AAA-rated debt to equity tranches. Investors can choose a tranche based on their risk tolerance and return objectives, with the riskiest equity tranches targeting mid-to-high teen returns and higher-rated tranches providing more stable, bond-like returns.

While CLOs were once "left for dead" after the 2008 financial crisis, the industry has made a remarkable comeback, as long-term holders achieved robust returns, Bates said.

"The reason CLOs keep growing is a combination of historical returns, the floating rate nature of the securities, and the active exposure to an actively managed pool of loans," he said.

The rise of CLO ETFs has also made this asset class more accessible to retail investors, driving demand even further. One of the key benefits of CLOs for financial advisors is the ability to offer clients a differentiated investment opportunity, Bates said.

“Instead of owning private credit loans directly, you might own the AAA that's issued by the CLO and in that case, there's lots of junior capital that would absorb the losses on the loans, if there are any,” Bates said.

The other end of the spectrum is CLO equity. “That's for somebody, like me, who really likes the private credit story, who thinks defaults aren't going to be elevated, and believes the profitability of the CLO is going to be very attractive,” he said.

CLOs offer several advantages that can benefit both advisors and clients. For one, they offer enhanced risk-adjusted returns.

For example, during the global financial crisis, CLO equity investments delivered internal rates of return in the high 20s on a buy-and-hold basis, Bates said.

Debt tranches, such as BB-rated securities, maintain a low annual default rate of approximately 0.25 percent, significantly outperforming high-yield bonds.

Advisors can align CLO investments with specific client goals. Conservative investors, for example, might favor AAA-rated debt or CLO-focused ETFs, while risk-tolerant clients targeting mid-to-high teen returns may find CLO equity appealing as a substitute for private equity or distressed debt exposure.

"For a client who wants less risk, the CLO BB notes could be a good fit,” Bates said. “That's for somebody who likes private credit but would prefer to be in a structure where there's already somebody who's signed up to take the primary risk on the loans.”

Additionally, one of the reasons that CLO securities offer very attractive risk adjusted returns is due to a complexity premium they have, he said.

“Buying a CLO equity or BB is not as simple as buying a stock through your e-trade account or a plain vanilla investment grade bond. CLO securities do require a fair amount of expertise,” he said.

CLOs have grown so much in the past few years for a few good reasons, he said. Not only have historical returns performed well for over 30 years but investors aren’t taking any duration risk, making CLOs particularly attractive in rising interest rate environments.

“I think a lot of investors find that attractive. CLOs give this active exposure to an actively managed pool of personally and senior secured loans and you get to pick whatever the risk return preference you have for yourself or for your firm,” he said.

To issue more CLOs, more loans need to be created, he said.

“We're not seeing a lot of leveraged buyout activity. We've seen a lot of capital raised by private equity firms, but there's been a delay in getting that deployed over the last years,” he said.

“If that picks up in 2025, as it's expected to, then the industry will grow even further.”

Bates is continuously educating advisors on the CLO market. He’s author of the book CLO Investing – With an Emphasis on CLO Equity & BB Notes and hosts the podcast The CLO Investor Podcast.