A collateralized loan obligation or CLO is a security backed by the receivables on loans. It is also defined as a special purpose vehicle (SPV) with securitization payments in the form of different tranches. A CLO is actually just one type of collateralized debt obligation (CDO).
Collateralized loan obligations are created by pooling together payments from various middle-sized and large business loans. These payments are then given to the investors in different tranches.
These tranches, or classes, determine the interest rate received by each investor. In CLOs, investors do not get the same amount of interest, with the investors taking or absorbing the greatest risk getting more interest payments than investors in other tranches.
The advantage of this setup is that investors get to choose which tranche to belong to, and thus have a certain degree of control in their investment risk. This is also advantageous to the financial institutions that sell the security since they get to attract more investors.
CLOs were created with two reasons in mind: lowering the cost of borrowing for the business and reducing the risk of lending to the banks, since they sell the loans off to external investors.
While it is possible for the borrowing businesses to go directly to the external investors to ask for a loan, it will be much harder to get approved, because it will mean a higher risk for the investor since the loan will not offer a diversified portfolio.
