CLO Structure: Capital Stack, Tranches, and Payment Waterfall

The structural mechanics of a CLO—how it transforms a pool of BB-rated loans into securities where 60-65% are rated AAA—are the foundation of the asset class. Understanding tranching, subordination, and the payment waterfall is essential for evaluating CLO investments across the capital structure.

The Capital Stack: Typical CLO Tranche Structure

A standard $500 million CLO issues multiple layers of debt and equity, each with distinct risk-return profiles:

Note: Exact sizing and ratings vary by deal, manager tier, and market conditions. Some CLOs have additional tranches (e.g., A-1/A-2 splits) or combine certain classes.

How Subordination Creates AAA from BB

The core structural principle: junior tranches absorb losses before senior tranches.

Example: Loss Waterfall Scenario

Consider a $500M CLO with the structure above. Assume the underlying loan portfolio experiences $50M in cumulative losses over the life of the deal (10% default rate × 50% loss severity):

1. Equity absorbs first $40-60M: Equity investors lose their entire investment.
2. Class E (BB) absorbs next $20-30M: If losses exceed equity cushion, BB tranche takes losses.
3. Classes D, C, B absorb subsequent losses: Only after equity and BB are wiped out.
4. Class A (AAA) remains unimpaired unless losses exceed $140-200M (28-40% of the portfolio)—a scenario that has never occurred in CLO history.

This is why a pool of BB-rated loans can produce AAA-rated securities: the $300M AAA tranche has $140-200M of subordination protecting it (28-40% loss cushion).

The Payment Waterfall: Priority of Payments

CLO indentures specify a strict order in which cash flows from the loan portfolio are distributed. This "waterfall" ensures senior creditors are paid before junior creditors and equity.

Interest Waterfall (Quarterly)

Every quarter, interest collected from underlying loans flows through the structure in this order:

1. Fees and expenses: Trustee fees, administrative costs, rating agency fees (~5-10 bps)
2. Senior management fees: Paid to the CLO manager (~30-40 bps annually, paid quarterly)
3. Class A interest: AAA tranche receives its full coupon (SOFR + spread)
4. Class B interest: AA tranche receives its full coupon
5. Class C interest: A tranche receives its full coupon
6. Coverage test compliance checks:
   • If OC or IC tests fail, divert cash to pay down senior tranches instead of paying junior interest
   • Learn more about coverage tests →
7. Class D interest: BBB tranche (if tests pass)
8. Class E interest: BB tranche (if tests pass)
9. Subordinated management fees: Additional fees contingent on performance
10. Equity distributions: Residual cash flows to equity investors (if all senior obligations met and tests pass)

Principal Waterfall

Principal payments (from loan repayments, sales, or defaults) follow a similar waterfall:

• During reinvestment period (first 4-5 years): Principal is reinvested in new loans to maintain portfolio size, except when needed to cure coverage test failures.
• After reinvestment period: Principal pays down tranches sequentially from AAA down to equity.
• Coverage test failures: If OC/IC tests fail, principal is used to pay down AAA tranche early, restoring OC ratios.

Waterfall During Distress: Coverage Tests in Action

When the loan portfolio deteriorates (e.g., ratings downgrades, defaults), coverage tests may fail. This triggers a "cash trap" mechanism:

• Interest that would go to equity/mezzanine is instead redirected to pay down AAA/AA tranches.
• Purpose: Delever the structure, increasing the subordination cushion protecting senior tranches.
• Effect on equity: Equity receives zero cash flows until tests are cured, which can take months or years.

Example: A CLO's overcollateralization (OC) test falls below the required threshold due to loan downgrades. The next quarterly payment that would distribute $3M to equity is instead used to pay down $3M of the AAA tranche. This continues until the OC ratio is restored.

Overcollateralization: The Key Protection Mechanism

CLOs maintain more assets than liabilities at every level of the capital structure. This "overcollateralization" provides a cushion against losses.

Overcollateralization Ratio Formula

OC Ratio = (Par Value of Assets) / (Par Value of Liabilities)

Typical OC Test Levels (for AAA Tranche)

• AAA OC Ratio: Typically 125-140%
• Interpretation: For every $1.00 of AAA liabilities, there is $1.25-1.40 of asset collateral.
• Trigger: If the ratio falls below the trigger level (e.g., 127%), the CLO redirects cash flows to delever until the ratio is restored.

How Defaults Impact OC Ratios

Assume a CLO has:

• $500M in loan assets (par value)
• $300M in AAA liabilities
• AAA OC Ratio: 500 / 300 = 167%
• AAA OC Test Trigger: 130%

If $50M of loans default and are written down to $10M (80% loss):

• New asset value: $500M - $50M + $10M = $460M
• New AAA OC Ratio: 460 / 300 = 153%
• Result: Test still passes (153% > 130%). AAA investors unaffected.

If defaults continue and asset value falls to $380M:

• New AAA OC Ratio: 380 / 300 = 127% (below 130% trigger)
• Result: Cash trap activates. Equity/mezzanine interest diverted to pay down AAA tranche until ratio exceeds 130%.

Read detailed coverage test mechanics →

Why Some CLOs Have Multiple AAA Tranches

Many CLOs split the AAA class into A-1 and A-2 (or A-1, A-2, A-3) tranches:

• A-1: Often floating-rate notes with shorter weighted average life.
• A-2: May have slightly wider spreads; typically amortizes after A-1 is fully repaid.
• Purpose:
  • Meets different investor preferences (some want shorter duration, others want longer)
  • Provides liquidity—smaller tranches can trade more easily
  • Allows manager to match investor demand during issuance

Note: A-1 and A-2 have the same legal seniority (pari passu) but may differ in amortization schedules.

Equity: The Residual Tranche

CLO equity (also called the "subordinated notes" or "income notes") is the riskiest and highest-returning tranche:

Equity Characteristics

• First-loss position: Absorbs all defaults and downgrades before any debt tranche is impaired.
• No fixed coupon: Receives residual cash flows after all debt and fees are paid.
• Highly sensitive to defaults: A 2% increase in default rates can reduce equity IRRs by 300-500 bps.
• Illiquid: Difficult to sell in secondary markets; typically held to maturity.
• Target returns: 12-18% gross IRR, but highly variable by vintage and manager.

Equity Return Drivers

Equity returns depend on:

1. Spread arbitrage: Difference between loan yields (SOFR + 450 bps avg.) and debt costs (SOFR + 140 bps weighted avg.)
2. Default and recovery performance: Losses reduce equity cash flows directly
3. Manager trading skill: Ability to upgrade portfolio quality and capture market opportunities
4. Reinvestment period management: Maintaining spread arbitrage as loans prepay and are replaced

Learn more about CLO equity investing →

Static vs. Managed Structures

Most CLOs are managed, meaning the manager can buy and sell loans during the reinvestment period. However, some structures are static:

Managed CLOs dominate because active management demonstrably improves risk-adjusted returns, especially during credit cycles.

Structural Protections Beyond Subordination

In addition to tranching, CLOs incorporate multiple protective covenants:

1. Diversity Requirements

• Minimum number of obligors: Typically 150+ distinct borrowers
• Single-obligor limits: No more than 2-3% exposure to any one company
• Industry concentration limits: Maximum 10-15% in any industry (e.g., healthcare, energy)
• Geographic limits: Caps on non-U.S. exposure (for U.S. CLOs)

2. Credit Quality Constraints

• CCC bucket: Maximum 7.5% of portfolio can be CCC-rated
• Weighted Average Rating Factor (WARF): Portfolio average rating must stay above minimum threshold
• Defaulted obligations: Limits on how long defaulted loans can remain in portfolio

3. Cash Flow Tests

• Overcollateralization (OC) tests: Asset value vs. liability thresholds at each tranche level
• Interest Coverage (IC) tests: Interest income vs. interest expense ratios
• Frequency: Tested monthly or quarterly; failures trigger cash diversions

Par vs. Market Value: A Critical Distinction

CLO mechanics typically use par value (face amount) rather than market value for coverage tests:

• Par-based OC tests: A loan purchased at 95 cents counts as $1.00 for OC purposes (if performing).
• Advantage: Protects against short-term market volatility. A temporary price decline doesn't trigger test failures.
• Risk: A loan trading at 70 cents due to credit deterioration still counts as $1.00 until it defaults or is downgraded to CCC/defaulted.
• Mitigation: Rating-based haircuts—loans rated CCC are often valued at 70-85 cents for test purposes.

Next Steps

• Tranches Explained – Detailed comparison of debt tranche investment profiles
• Coverage Tests – How OC/IC tests protect investors
• CLO Lifecycle – From warehousing to final maturity
• CLO Equity Investing – Deep dive on equity risk and returns
• CLO Debt Investing – Strategies for AAA through BBB tranches