CLO Interest Rate Risk
CLOs are floating-rate securities with near-zero duration risk. Both assets (leveraged loans) and liabilities (CLO tranches) reset quarterly based on SOFR, creating a natural hedge against interest rate movements. This makes CLOs dramatically less sensitive to rate changes than fixed-rate high yield bonds—a key structural advantage that became especially valuable during 2022-2024's rapid rate increases.
Why CLOs Have Minimal Interest Rate Risk
Floating-Rate Structure
Assets (leveraged loans): SOFR + spread (e.g., SOFR + 450 bps), reset quarterly
Liabilities (CLO tranches): SOFR + spread (e.g., SOFR + 150 bps AAA), reset quarterly
Example: What happens when SOFR increases
| Scenario | SOFR Rate | Asset Yield (SOFR+450) | AAA Cost (SOFR+150) | Net Spread |
|---|---|---|---|---|
| Low rates (2021) | 0.05% | 4.55% | 1.55% | 3.00% |
| Rising rates (2022) | 3.00% | 7.50% | 4.50% | 3.00% |
| High rates (2024) | 5.35% | 9.85% | 6.85% | 3.00% |
Key insight: Net spread (asset yield minus liability cost) remains constant at 300 bps regardless of SOFR level. Both sides of the balance sheet move in parallel.
Duration Comparison: CLOs vs. Bonds
| Security Type | Duration | Price Change if Rates ↑ 1% | 2022 Performance (Rates ↑ 3%) |
|---|---|---|---|
| AAA CLO | 0.1 years | -0.1% | +1.5% (rates helped) |
| BBB CLO | 0.2 years | -0.2% | -2.8% (credit spread widening) |
| HY Bonds (BB) | 4.5 years | -4.5% | -12.5% (duration + credit) |
| Investment Grade Corporates | 7.2 years | -7.2% | -18.2% (worst since 2008) |
| 10Y Treasury | 8.5 years | -8.5% | -16.4% |
Real-world example (2022 rate shock): When Fed raised rates 425 bps in 2022, AAA CLOs returned +1.5% while IG corporate bonds fell -18%. CLO floating-rate coupons increased, offsetting modest credit spread widening.
The 2022-2024 Case Study
What Happened
Federal Reserve raised rates from 0.25% (March 2022) to 5.50% (July 2023) to combat inflation—fastest hiking cycle since 1980s.
Impact on Different Securities
| Asset Class | 2022 Return | 2023 Return | 2-Year Cumulative |
|---|---|---|---|
| AAA CLOs | +1.5% | +7.2% | +8.8% |
| BBB CLOs | -2.8% | +11.5% | +8.4% |
| Leveraged Loan Index | -0.5% | +13.2% | +12.6% |
| High Yield Bonds | -11.2% | +13.4% | +0.7% |
| Investment Grade Corporates | -15.8% | +5.5% | -11.1% |
| Aggregate Bond Index | -13.0% | +5.5% | -8.2% |
Key takeaway: AAA CLOs posted +8.8% cumulative returns while IG corporate bonds fell -11.1% during identical period. Floating-rate structure insulated CLO investors from duration risk.
Components of Interest Rate Risk
1. Base Rate Risk (SOFR Changes)
Definition: Risk that changes in SOFR affect security value.
CLO impact: Near-zero. Both assets and liabilities move with SOFR, preserving spread.
Exception: SOFR floor benefit. If SOFR falls below floor (typically 0-50 bps), asset yields stay at "SOFR floor + spread" while liabilities continue to fall. This benefits equity holders in low-rate environments.
2. Credit Spread Risk
Definition: Risk that the spread over SOFR (e.g., +150 bps for AAA) widens or tightens due to credit market conditions.
CLO impact: Moderate. Spread widening reduces market value; spread tightening increases value.
Historical AAA CLO spread ranges:
- Tightest: SOFR + 110 bps (Q4 2021, peak demand, low supply)
- Widest: LIBOR + 250 bps (Q2 2020, COVID panic, illiquidity premium)
- Current (2024): SOFR + 120-150 bps (normalized)
What drives spread movements:
- Credit market sentiment (risk-on vs. risk-off)
- CLO supply/demand dynamics (heavy issuance widens spreads)
- Competing asset class yields (e.g., corporate bonds, direct lending)
- Regulatory changes affecting bank demand
- Default rate expectations
3. Prepayment Risk
Definition: Risk that loans prepay early (refinance), shortening effective maturity.
Impact on CLO debt holders:
- Rising rate environment: Good for investors (keep high coupon longer; prepayments slow)
- Falling rate environment: Bad for investors (loans refinance; forced to reinvest at lower spreads)
CLO structural protections:
- During 4-5 year reinvestment period: Manager reinvests prepayments into new loans (maintains maturity)
- After reinvestment period: Prepayments flow through to debt holders pro-rata (amortization begins)
4. Extension Risk
Definition: Risk that effective maturity extends beyond expectations.
When this happens:
- Poor credit performance: OC test failures divert cash to pay down senior debt, extending equity payout
- Manager exercises refinancing/reset: Extends reinvestment period 3-5 years
- Loans default and enter workout: Recovery takes 12-36 months
Impact: Investors must hold positions longer than anticipated, creating opportunity cost.
Who Benefits from Rising Rates?
CLO Equity Holders: Big Winners
Rising rates dramatically benefit CLO equity through increased cash flow:
Example: $500M CLO with $50M equity (10% of capital)
| SOFR Environment | Asset Yield | Debt Cost | Net Spread | Equity Cash Flow | Equity Yield |
|---|---|---|---|---|---|
| Low (0.05%, 2021) | 4.55% | 1.75% | 2.80% | $8.1M | 16.2% |
| Rising (3.00%, 2022) | 7.50% | 4.70% | 2.80% | $8.1M | 16.2% |
| High (5.35%, 2024) | 9.85% | 6.85% | 3.00% | $8.8M | 17.6% |
Additional benefit - SOFR floor: When SOFR was 0.05% (2021), many loans had 0.50% floors. Effective asset yield = SOFR floor (0.50%) + spread (4.50%) = 5.00%, while liability cost = actual SOFR (0.05%) + spread (1.70%) = 1.75%. This created 40-50 bps of "excess spread" benefiting equity.
CLO Debt Holders: Neutral to Positive
- Higher income: Quarterly coupons increase with SOFR (SOFR 5.35% + 150 bps = 6.85% AAA yield in 2024 vs. 1.55% in 2021)
- Mark-to-market impact: Minimal, since duration near-zero
- Credit spread risk: Some spread widening during rate hikes (risk-off sentiment), but far less than fixed-rate bonds
Who Loses from Rising Rates?
Fixed-Rate Bond Holders: Big Losers
High yield bonds and investment-grade corporates suffered double-digit losses in 2022:
- Duration impact: 4-7 year duration × 3-4% rate increase = 12-28% price decline
- Credit spread widening: Additional 1-3% from risk-off sentiment
- No coupon increase: Fixed 5% coupon stays 5% even as market yields rise to 8-9%
Strategic Implications for Investors
When to Favor CLOs Over Bonds
Rising rate environment (like 2022-2024):
- CLOs outperform due to floating coupons and minimal duration
- AAA CLOs offer 5.5-6.8% yields with near-zero rate risk
- High yield bonds suffer from duration losses despite higher coupons
Falling rate environment (like 2019-2020):
- Fixed-rate bonds outperform (capital appreciation as rates fall)
- CLO coupons decline with SOFR (though spread maintained)
- SOFR floor becomes valuable cushion for CLO assets
When to Favor Bonds Over CLOs
Stable rate environment with falling credit spreads:
- Fixed-rate HY bonds capture capital gains from spread tightening
- CLOs see modest spread tightening but limited capital appreciation
- Example: 2010-2014, rates stable and credit spreads compressed 200-300 bps; HY bonds returned 10-13% annually
LIBOR to SOFR Transition (2021-2023)
What Changed
CLO market transitioned from LIBOR (London Interbank Offered Rate) to SOFR (Secured Overnight Financing Rate) as benchmark:
- LIBOR: Based on bank lending rates (ceased Dec 2021 for USD)
- SOFR: Based on U.S. Treasury repo market (more robust, less manipulation risk)
Impact on CLOs
- Spread adjustment: SOFR typically 10-30 bps lower than LIBOR; spreads widened to compensate (e.g., LIBOR+450 → SOFR+465)
- Term structure: SOFR has 1M, 3M, 6M tenors (like LIBOR)
- Transition smoothness: 100% of new CLOs now SOFR-based; legacy LIBOR CLOs amended successfully
- Economic impact: Neutral; transitional adjustments preserved economics
Key Takeaways
- CLOs have near-zero duration risk due to floating-rate structure (both assets and liabilities reset quarterly)
- 2022 case study: AAA CLOs +8.8% while IG corporate bonds -11.1% during rate shock
- Rising rates benefit CLO equity holders (increased cash flows, SOFR floor benefits)
- CLO debt holders neutral to positive (higher income, minimal duration impact)
- Fixed-rate bonds suffer in rising rate environments (duration losses 4-8% per 1% rate increase)
- Credit spread risk exists but far smaller than duration risk for fixed-rate securities
- LIBOR → SOFR transition completed smoothly (no economic impact)