CLO Credit Risk
Credit risk—the possibility that underlying leveraged loan borrowers default on obligations—is the primary risk facing CLO investors. However, CLO structures employ multiple layers of protection (diversification, subordination, coverage tests, active management) that have historically proven remarkably effective. Since 1994, zero AAA CLO tranches have defaulted despite multiple recessions and the 2008 financial crisis.
Sources of Credit Risk
1. Obligor Default Risk
The fundamental risk: companies in the loan portfolio cannot repay their debts and enter bankruptcy or restructuring.
Historical default rates (leveraged loans, 1997-2024):
- Long-term average: 3.2% annually (par-weighted)
- Best years: 0.5-1.5% (2021-2024, low-rate environment)
- Worst year: 9.8% (2009, Great Financial Crisis peak)
- COVID peak: 3.4% (2020, muted by Fed intervention)
What drives defaults:
- Recession/economic contraction: Revenue decline → EBITDA decline → inability to service debt
- Industry disruption: Technology shifts (retail vs. e-commerce), commodity crashes (oil & gas)
- Overleveraging: Debt/EBITDA > 7x leaves no cushion for downturns
- Operational missteps: Failed acquisitions, product recalls, management turnover
- Refinancing risk: Cannot refinance maturing debt during credit market dislocation
2. Industry Concentration Risk
CLO indentures limit single-industry exposure (typically 15-20% max), but certain sectors carry systematically higher default risk:
| Industry | Default Rate (2000-2024) | Risk Level | Key Drivers |
|---|---|---|---|
| Retail / Apparel | 6.8% | Very High | E-commerce disruption, margin compression |
| Energy / Oil & Gas | 5.5% | High | Commodity price volatility |
| Restaurants / Leisure | 4.2% | Moderate-High | Consumer discretionary, location risk |
| Manufacturing | 3.5% | Moderate | Cyclical demand, supply chain disruption |
| Business Services | 2.8% | Low-Moderate | Diversified revenue, sticky customers |
| Healthcare | 2.2% | Low | Defensive, non-cyclical demand |
| Software / Tech | 1.8% | Low | Recurring revenue, high margins |
3. Recovery Risk
When loans default, recovery rates determine ultimate losses. First lien secured loans historically recover 70-80%, but recovery varies by capital structure and economic conditions.
Recovery rates by seniority (1990-2024):
- 1st lien secured: 76% average (range: 55-95%)
- 2nd lien secured: 42% average (range: 15-70%)
- Senior unsecured: 51% average (range: 20-75%)
- Subordinated: 28% average (range: 5-50%)
What drives recovery rates:
- Collateral value: Hard assets (real estate, equipment) recover better than intangibles
- Going concern value: Viable businesses reorganize and pay creditors; liquidations yield less
- Capital structure seniority: 1st lien gets paid first
- Economic cycle: 2009 recoveries averaged 68% (distressed buyers); 2021 recoveries averaged 82% (ample liquidity)
- Bankruptcy efficiency: Chapter 11 restructurings faster and more valuable than Chapter 7 liquidations
How CLOs Mitigate Credit Risk
1. Diversification
CLOs hold 150-300 loans to 150-300 different borrowers across 20-30 industries. This eliminates idiosyncratic single-obligor risk.
Diversification limits (typical indenture):
- Single obligor: Maximum 2-3% of portfolio (no single default can cause >2-3% loss)
- Single industry: Maximum 15-20% exposure
- Single obligor group: Maximum 5% (prevents multiple related companies)
- Geographic concentration: Often 85%+ U.S./Canada (limits emerging market exposure)
Impact example: If 1 obligor out of 200 defaults (0.5% of portfolio) and recovers 70%, net loss = 0.15% of portfolio value—absorbed entirely by equity tranche.
2. Subordination
Lower tranches absorb losses before senior tranches are impaired. This creates massive cushion for AAA/AA/A holders.
| Tranche | Subordination | Default Rate to Impair | Scenario |
|---|---|---|---|
| AAA | 35-40% | 60-70% | 3× worse than 2009 peak (9.8%) |
| AA | 27-32% | 50-60% | 2.5× worse than 2009 |
| A | 20-25% | 40-50% | 2× worse than 2009 |
| BBB | 13-18% | 30-40% | 1.5× worse than 2009 |
| BB | 8-12% | 20-30% | Severe recession scenario |
| Equity | 0% | 15-20% | Extended recession (2008-2010 cumulative) |
Real-world test (2008-2009): Cumulative default rate reached ~15% (2008-2010 combined). Result: Zero AAA defaults, near-zero AA defaults, <1% BBB defaults.
3. Coverage Tests (OC/IC)
Overcollateralization and Interest Coverage tests automatically divert cash from junior tranches to senior tranches if portfolio credit quality deteriorates.
How OC tests protect against defaults:
- AAA OC test typically requires 127-132% ratio (collateral par value / AAA+AA+A+BBB par)
- When loans default, par value drops → OC ratio falls
- If OC ratio falls below trigger (e.g., 130%), equity distributions cease and all cash flows to senior tranches
- This "turbocharges" deleveraging, protecting AAA/AA holders
2008-2009 example: Many BBB OC tests failed (cash diverted from equity/BB to AAA/AA/BBB). This prevented BBB payment defaults despite 10% portfolio default rates.
4. Active Management
Unlike passive securitizations (RMBS), CLO managers actively trade loans during 4-5 year reinvestment period:
- Sell deteriorating credits: Manager spots weakening fundamentals (covenant breaches, declining EBITDA) and exits before default
- Upgrade portfolio quality: Trade out of CCC-rated loans (20-30% default risk) into B-rated loans (4-5% risk)
- Sector rotation: Reduce exposure to cyclical industries during late cycle; increase defensive sectors
- Recovery maximization: Work with special situations team to maximize recoveries on defaulted positions
Impact: Tier 1 managers achieve 2.5% default rates vs. 3.2% for passive loan indices through active trading and credit selection.
Credit Risk by Tranche
AAA Tranches: Near-Zero Credit Risk
- Historical default rate: 0.00% since 1994 (30+ year track record)
- Payment deferral rate: 0.0% (never occurred)
- Stress scenario to impair: 60-70% cumulative defaults with 30% recoveries (apocalyptic scenario)
- Rating agency assumption: Model 31-40% default scenarios; AAA survives all stress tests
AA and A Tranches: Very Low Credit Risk
- AA historical default rate: <0.05% (near-zero)
- A historical default rate: 0.1-0.2%
- 2008-2009: Zero AA defaults; <1% of A tranches experienced temporary deferrals
- Stress scenario: Requires 40-60% defaults to impair
BBB Tranches: Low-Moderate Credit Risk
- Historical default rate: 0.58% (1994-2024)
- 2008-2009: 25% of BBB tranches experienced interest deferrals (lasting 12-24 months); most recovered
- Ultimate principal losses: 2-3% of BBB tranches from 2007-2008 vintages
- Risk profile: Lowest IG rating; HY-like yields (SOFR + 300-350 bps) with structural protection
BB and B Tranches: Moderate-High Credit Risk
- BB historical default rate: 2.14% (1994-2024)
- 2008-2009: 45% experienced deferrals; 10-15% suffered principal losses (15-30% loss severity)
- Trade-off: SOFR + 500-700 bps yields compensate for elevated risk
Equity: High Credit Risk, High Return
- First-loss position: Absorbs 100% of losses until wiped out
- 2008-2009: 90%+ of deals stopped distributions for 12-36 months
- 2007-2008 vintage equity: 3-7% IRRs (vs. 15% targets) due to defaults and deferral periods
- Default sensitivity: 1% increase in annual default rate = 200-300 bps reduction in equity IRR
Mitigating Credit Risk as an Investor
Tranche Selection
- Risk-averse: AAA/AA tranches (zero historical defaults, minimal mark-to-market risk)
- Balanced: A/BBB tranches (very low default risk, meaningful yield premium)
- Risk-seeking: CLO equity (high returns, but 90%+ probability of distribution interruption during recession)
Manager Selection
Tier 1 managers outperform by avoiding defaults:
- Tier 1 default rates: 2.5% (vs. 3.2% industry average)
- Impact on equity: 70 bps lower defaults = +300 bps equity IRR over 10 years
- 2008-2009 vintages: Tier 1 managers delivered 8-10% IRRs; Tier 3/4 delivered 2-5% or losses
How to evaluate CLO managers →
Vintage Selection
- Avoid late-cycle vintages: 2006-2007 (pre-crisis) and 2018-2019 (pre-COVID) vintages underperformed
- Target post-crisis vintages: 2009-2013 (post-GFC) delivered 18-22% equity IRRs; wide spreads compensated for elevated default expectations that never materialized
- Current environment (2024-2025): Default rates normalizing to 2.5-3.5%; reasonable entry point for new CLOs
Portfolio Diversification
- For equity investors: Invest across 5-10 CLO managers to diversify manager risk
- For debt investors: Hold 10-20 different CLOs to diversify single-deal risk
- Vintage diversification: Dollar-cost average across multiple vintage years to avoid concentration in single cycle
Key Takeaways
- Credit risk = underlying loan defaults; historical average 3.2%, peak 9.8% (2009)
- AAA tranches: Zero defaults in 30+ years; 35-40% subordination cushion
- Four mitigation layers: Diversification (200+ loans), subordination, OC tests, active management
- Default rates required to impair AAA: 60-70% (3× worse than 2009 GFC)
- Manager quality critical: Tier 1 managers achieve 2.5% defaults vs. 3.2% average
- CLO equity highly sensitive: 1% higher defaults = 200-300 bps lower IRR
- Recovery rates: 1st lien loans recover 76% on average (vs. 40-50% for unsecured bonds)