CLO vs ABS: Key Differences in Structure and Investment

Collateralized Loan Obligations (CLOs) and Asset-Backed Securities (ABS) are both structured financial products, but they differ in ways that impact risk, returns, and investor appeal. Understanding these differences is essential for those looking to invest in or analyze securitized debt instruments.

While both CLOs and ABS pool assets to create investment opportunities, their structure, cash flow distribution, and regulatory considerations set them apart.

Types of Underlying Collateral

The assets backing CLOs and ABS shape their risk profiles and investor appeal. CLOs are backed by leveraged loans—debt issued to companies with below-investment-grade credit ratings. These loans are typically senior secured, meaning they have repayment priority in case of default. Because they involve higher credit risk, they offer higher yields, attracting investors seeking enhanced returns. CLOs are actively managed, with a collateral manager buying and selling loans to optimize performance.

ABS encompass a broader range of asset types, including auto loans, credit card receivables, student loans, and equipment leases. The credit quality of ABS varies widely. Prime auto loan ABS, backed by borrowers with strong credit histories, have lower default risk than subprime auto loan ABS, which involve weaker credit profiles. Unlike CLOs, ABS pools are generally static, meaning the assets are not actively traded once securitized.

CLO performance is tied to corporate credit cycles, as leveraged loans are sensitive to economic conditions and interest rate movements. ABS performance depends on consumer credit trends, employment levels, and industry-specific factors. For instance, credit card ABS may see higher delinquencies during downturns, while auto loan ABS could be affected by used car value fluctuations.

Structural Characteristics

CLOs and ABS differ in management and risk protection. CLOs are actively managed, allowing a collateral manager to buy and sell loans to optimize returns and manage credit risk. This flexibility enables CLOs to adjust to market conditions, potentially mitigating losses from underperforming loans. The reinvestment period, typically four to five years, allows managers to replace maturing or downgraded loans with new ones.

ABS are typically structured as static pools, meaning the underlying assets remain unchanged throughout the life of the security. This fixed composition provides greater cash flow predictability but limits flexibility in responding to credit deterioration. Some ABS structures include revolving periods, particularly in credit card securitizations, where new receivables can be added for a defined period before amortization begins.

Both CLOs and ABS use credit enhancement mechanisms, but the methods differ. CLOs rely heavily on subordination, where lower-rated tranches absorb losses before senior tranches. This structure is reinforced by overcollateralization and interest coverage tests to ensure sufficient collateral and cash flow. ABS also use subordination but frequently incorporate additional credit enhancements, such as excess spread, reserve accounts, and third-party guarantees. For example, auto loan ABS may include a reserve fund that absorbs initial losses before affecting investors.

Cash Flow Allocation

Cash flow distribution in CLOs and ABS determines risk exposure and return potential for investors. CLOs use a sequential payment structure, where interest and principal payments first cover administrative expenses. After these obligations, cash flows go to senior noteholders before being distributed to subordinated tranches. This ensures senior investors receive payments first, reducing their risk while exposing junior tranches to potential losses.

ABS often employ a combination of sequential and pro-rata payment structures, depending on the deal terms and asset type. In many ABS transactions, senior tranches receive a fixed proportion of available cash flows, while subordinated tranches receive what remains. Some structures include performance triggers that can shift cash flow allocation dynamically. For example, if delinquency rates exceed a threshold, the deal may switch from pro-rata to sequential payments to protect senior bondholders.

Another distinction is how excess spread—the difference between interest earned on assets and interest paid to investors—is utilized. In CLOs, excess spread is typically reinvested during the reinvestment period or used to pay down liabilities. In ABS, it may be trapped in a reserve account for additional credit support before being released as residual income to equity holders. This treatment significantly impacts returns, particularly for lower-tranche investors.

Rating Approaches

Credit rating agencies evaluate CLOs and ABS using different methodologies. CLO ratings rely on the credit quality of leveraged loans, assessing factors like obligor diversity, industry concentration, and default probability. A key metric is the Weighted Average Rating Factor (WARF), which aggregates loan credit ratings into a single risk measure. Agencies also conduct stress scenario analysis, incorporating default correlations and recovery rate assumptions.

ABS ratings focus on the historical performance of the asset class, borrower characteristics, and structural protections. Rating agencies analyze delinquency and default trends within similar pools to estimate expected losses. For consumer-based ABS, such as credit card or auto loan securities, credit scoring models and past payment behavior play a key role in determining risk. Structural features, including credit enhancement levels and cash flow triggers, are also scrutinized to ensure senior tranches maintain high credit quality.

Tax and Accounting Treatments

The tax and accounting treatment of CLOs and ABS differs based on structure, jurisdiction, and regulations, influencing how investors and issuers recognize income, report liabilities, and manage tax obligations.

Tax Treatment

CLOs are typically structured as special purpose vehicles (SPVs) domiciled in tax-neutral jurisdictions such as the Cayman Islands to avoid corporate taxation at the entity level. Instead, income is passed through to investors, who are taxed based on their jurisdictions. U.S. investors may be subject to taxation on interest income and capital gains, depending on their holding period and tax status. CLO equity investors often face additional tax complexities, including potential Unrelated Business Taxable Income (UBTI) for tax-exempt entities like pension funds.

ABS tax treatment varies by asset type and structure. Many ABS transactions qualify as grantor trusts or real estate mortgage investment conduits (REMICs) under U.S. tax law, providing pass-through treatment that avoids double taxation. However, some ABS structures, particularly those involving revolving assets like credit card receivables, may be classified as debt instruments, subjecting investors to ordinary income taxation rather than capital gains treatment.

Accounting Treatment

Under U.S. Generally Accepted Accounting Principles (GAAP), CLOs and ABS are accounted for differently depending on whether they qualify for off-balance-sheet treatment. CLOs are often structured to meet the criteria for Variable Interest Entities (VIEs) under ASC 810, requiring consolidation by the primary beneficiary—typically the collateral manager or a major investor with controlling interest. This can impact financial statements by increasing reported assets and liabilities, affecting leverage ratios and regulatory capital requirements.

ABS accounting treatment depends on whether the securitization qualifies as a true sale under ASC 860. If the transferor surrenders control over the assets, the transaction is treated as a sale, allowing the originator to remove the assets from its balance sheet. If not, the securitization is accounted for as secured borrowing, requiring the issuer to retain the assets and recognize the associated liabilities. This distinction is particularly important for financial institutions, as it affects capital adequacy calculations under Basel III regulations.