Laila Kollmorgen, Global Head of CLO Tranche Investing at MetLife Investment Management, joins The CLO Investor podcast to discuss her investment approach across the CLO capital structure and the products her team manages. Laila shares why she currently sees compelling opportunities in CLO equity, junior BBBs, and AAAs, while offering insights on software credit risk, AI disruption, private credit, and the evolving outlook for leveraged loans and CLOs.
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18
Jun
2026
Are CLO BB Notes Misrated?
CLO Ratings
When a Collateralized Loan Obligation (CLO) is formed, a rating agency such as Moody’s Investors Service (Moody’s), Standard and Poor’s (S&P) or Fitch Ratings provides an independent public assessment of the credit quality of the CLO’s financing.
A typical CLO bundles together pools of first lien loans which are financed by issuing a series of debt notes (ranging in credit rating from AAA to BB) as well as an equity tranche that will absorb the first losses on the loans.
These are estimates of the size of broadly syndicated CLOs and can vary from CLO to CLO
To assign credit ratings to a CLO’s debt notes, rating agencies consider: 1) the underlying credit ratings of the CLO’s loans; 2) the likely recovery rate of the loans if they default; and 3) whether loan defaults in the CLO’s portfolio are likely to be correlated.
The CLO’s first lien loans are usually rated ‘B’ using the S&P credit ratings scale or ‘B2’ using the Moody’s scale. Individual loan ratings are determined by fundamental factors of the business, such as firm leverage, interest coverage, historical revenue and profitability growth, and the cyclicality of the business. A loan rated ‘BB’ by S&P, for example, is summarized qualitatively as: “Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.” Each credit rating also corresponds to quantitative probabilities that the issuer will default over various time periods. The higher the rating, the lower the probability that the loan will default.
A portfolio of highly correlated loans presents greater risk to the CLO’s debt notes. As a result, CLOs are required to be highly diversified by issuer and industry category. The ratings process often includes a Monte-Carlo computer simulation where thousands of potential scenarios of loan losses are modeled. From these simulations, a rating can be assigned.
BB CLOs Appear Structurally Underrated
Rating agencies rate many different types of securities: loans, corporate bonds, government bonds, Commercial Mortgage-Backed Securities (CMBS), CLOs, etc. Each rating is standardized to reflect an assessment of credit quality meant to be comparable across all asset types. In other words, a CLO BB note should have the same credit quality as a ‘BB’ rated corporate bond.
However, a comparative review of real-world default performance suggests that CLO securities are structurally underrated. CLO BB notes exhibit a 0.22% annualized default rate, which is significantly lower than the 1.40% annualized default rate for Corporate BB notes — by a factor of 6.3x.
As shown below, CLO BBs have a default experience that is closer to corporate credits rated investment grade (‘BBB’ or ‘A’).
Source: Standard and Poor’s. The time periods correspond to the data sets provided by the agency.
Potential Explanations for Rating Differentials
There are a few reasons why default probabilities may differ between corporates and CLOs. First, defaults in both corporates and CLOs are rare, so calibrating models with matching default probabilities for a given rating can be difficult. At any point in time, CLOs may be outperforming corporates or vice versa. Also, the data set for CLO securities begins in 1994, while the corporate data set begins in 1981.
Default differences may also stem from the fact that today’s CLOs are often associated with the failed Collateralized Debt Obligations (CDOs) from the Global Financial Crisis (GFC). While both securities are three-letter acronyms beginning with ‘C,’ they are very different: CLOs own highly diversified pools of actively managed senior secured loans, while CDOs’ assets were subprime mortgages of dubious credit quality, and as a result many CDOs saw defaults even in securities initially rated AAA.
Following the GFC, rating agencies tightened their methodologies when assessing structured credit. CLO notes were required to include additional credit protections even though senior and junior CLO debt generally performed well on a buy-and-hold basis through the crisis.
The combination of already resilient structures and more conservative post-GFC rating standards strengthened the credit profile of modern CLOs.
An additional potential explanation is that rating agencies do not give credit for the value that a CLO manager provides. Most CLO managers focus on assembling loan portfolios that are more conservative than the overall loan market, and many CLO managers avoid loans that default.
Structural Protections for CLO BB Notes
The most important protection for the CLO BB note is the initial equity contributed to the CLO, which takes the first losses on the loan portfolio.
If a loan portfolio underperforms (e.g., too many loans default or too many loans are downgraded to a CCC rating), the CLO has structural protections that can redirect the CLO’s profitability to benefit the noteholders. This diverted cash flow can be used to either buy more loans or de-lever the CLO, both of which result in increased credit protection for the CLO notes.
A key question for any investor in a CLO BB is: “What percent of the loans would need to default each year, such that the CLO BB noteholder does not receive all of their contractual interest and principal?” To perform this analysis, a projected recovery rate of the defaulted loans needs to be assumed. CLOs are typically modeled with a 70% recovery rate assumption, with a downside case recovery rate of 50%. The solid blue line in the graph below shows the actual default rate for the loan market, which peaked at 8% during the GFC. The dashed horizontal lines show the annual default rate required for the CLO BB to miss any contractual payments, assuming various recovery rates on the defaulted loans.
Source: Internal modeling using Intex, JP Morgan Default Monitor (April 2026). Results are from a hypothetical new-issue private credit CLO with a four-year reinvestment period and a hypothetical broadly syndicated CLO with a five-year reinvestment period. Assumes a pre-payment rate of 25%.
Private credit CLO BBs begin their lives with 12% equity and are highly resilient to loan defaults. Assuming a 70% recovery rate, private credit CLO BBs would survive 2.5x the default rate of the GFC and could withstand that elevated default rate for a duration of eight years. For a broadly syndicated CLO BB with initial equity of 8%, the default rate required to impair the CLO BB falls to 12%.
Lower projected loan recoveries result in lower required loan default rates for CLO BB impairment. However, even at a 50% recovery rate, CLO BBs can withstand substantial defaults.
Importantly, the above analysis does not capture the power of the CLO’s “self-healing” mechanism. When default rates rise, CLOs in their reinvestment period can benefit from their ability to buy discounted loans in the market, which provides additional collateral for the CLO BB. The chart above assumes all new loans are bought at a price of 99, which would be a conservative assumption in a recessionary environment.
Putting it All Together
As the chart below illustrates, CLO BBs default at 0.22% annually – a testament to the strong structural protections provided by the CLO structure. This default rate contrasts sharply with the annual default rates for high yield bonds and leveraged loans, which are 3.8% and 2.7%, respectively.
Source: High Yield Bond and Leveraged Loan annual default rates are 25-year average rates (including distressed exchanges) from JP Morgan Default Monitor (April 2026); CLO BB Default Rate is from S&P Global Ratings beginning 1994 and assumes a five-year average life. First lien loans, high yield bonds, and second lien loans are different in many respects including default rates, returns, and volatility. Past performance is not indicative of future results.
Although CLO BBs have historically experienced significantly lower default rates than high yield bonds and leveraged loans, they have generally offered investors a yield premium.
Source: US CLO BB yield is reported by Palmer Square CLO BB Yield index. US HY Corporate bonds is derived from the Yield function on Bloomberg for the iShares iBoxx USD High Yield Corporate Bond ETF.
We view this incremental yield as compensation for the illiquidity and complexity associated with the asset class, rather than a reflection of weaker underlying credit fundamentals.
DISCLOSURES
Past performance is not indicative of future results.
This is not an invitation to make any investment or purchase shares in any fund and is intended for informational purposes only. Nothing contained herein constitutes investment, legal, tax or other advice, nor is it to be relied on in making an investment or other decision. Nothing herein should be construed as a solicitation, offer or recommendation to acquire or dispose of any investment, or to engage in any other transaction.
For further information feel free to email info@flatrockglobal.com
15
May
2026
#35, Cyrus Moshiri, Head of Structured Credit, New Mountain Capital
Cyrus Moshiri, Head of Structured Credit at New Mountain Capital, joins The CLO Investor podcast to discuss how New Mountain is differentiated from other private credit businesses, if private credit is as attractive as it used to be, the risk in software industry loans, and loan default rates in general.
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27
Apr
2026
#34, Chris York, Partner, SLR Capital
Chris York, Partner at SLR Capital, joins the CLO Investor Podcast to discuss the evolving landscape for BDCs and private credit, including publish BDC discounts, software loan risk, tender activity, and where risk-adjusted opportunities remain as the cycle matures.
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17
Apr
2026
Why Private Credit CLOs?
Why Private Credit CLOs?
April 2026
We believe private credit loan exposure can be compelling when accessed through CLOs. The CLO structure enhances diversification, defensiveness, leverage efficiency, and liquidity in ways that direct lending funds cannot easily replicate.
1. Diversification
In private credit, where individual credit outcomes can vary significantly, diversification is a powerful risk mitigant. CLOs provide investors with multiple forms of diversification:
- Broad borrower exposure: CLOs typically hold a diversified pool of senior secured loans (often 75 or more holdings).
- Industry caps: All CLOs include sector concentration limits (often around 10-15%), which may help reduce exposure to any single industry.
- Manager diversity: Allocating across multiple CLOs provides exposure to different underwriting teams, sourcing networks, and portfolio construction philosophies.
2. Defensiveness
CLOs concentrate on the conservative segment of private credit — senior secured, first-lien loans. These loans sit at the top of the borrower’s capital structure and may offer lenders certain protections in two key ways:
- First in line for repayment: These loans are generally first in line for repayment if a business faces operational challenges.
- Superior historical recoveries: Recovery rates on senior secured, first-lien loans have historically been higher than those on second-lien, unsecured, or subordinated debt that is often found in direct lending funds.
3. Leverage Efficiency
The CLO structure provides built-in leverage done on terms we believe are favorable and may be accretive to returns.
- Term-matched: Leverage is locked in for the life of the CLO, which may reduce refinancing risk.
- Non-mark-to-market: A CLO’s leverage is largely fixed at inception and is generally not contingent on changes in valuations of loans in the underlying portfolio. By comparison, many direct lending funds employ market-based financings.
4. Liquidity
CLOs are issued as securities, making them tradable and providing investors with a number of benefits when compared to direct lending funds.
- Liquidity: CLOs have an active primary and secondary market, which may enable investors to buy or sell these securities daily.
- Price discovery: Market-based pricing provides more timely transparency that is unavailable in many private credit funds.
Together, these features may make CLOs a structurally efficient and scalable way to access private credit while balancing risk, return, and liquidity.
Shiloh Bates
Chief Investment Officer
This document is intended for informational purposes only and does not constitute investment advice or a recommendation to buy or sell any security. The views expressed are subject to change and may not reflect those of all investment professionals. Past performance is not indicative of future results. Investments in CLOs involve risks, including possible loss of principal.
30
Mar
2026
#33, Drew Sweeney, Co-Head of Global Credit, TCW
Drew Sweeney, Co-Head of Global Credit of TCW, joins The CLO Investor podcast for a second time to discuss loans to software businesses at a time when AI-displacement risk is elevated. We discuss the question of if declining software valuations and cash flows will be severe enough to impair first lien loans.
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17
Mar
2026
#32, John Kim, CEO and Co-Founder, Reckoner Capital
John Kim, CEO and Co-Founder of Reckoner Capital, joins The CLO Investor podcast to discuss the launch of innovative CLO ETFs, including leveraged and reinvesting structures. The conversation also covers broader trends in the CLO market, risk considerations, and how institutional and retail investors may think about CLO debt today.
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06
Mar
2026
Captive CLO Equity Funds with Shiloh Bates
Captive CLO Equity Funds
One structural challenge for CLO equity investors in the years ahead is the growing prevalence of captive CLO equity funds, which purchased a substantial majority of the equity in CLOs created last year.
A third party CLO investor is not tied to deals from one CLO manager. Rather, they seek attractive risk-adjusted returns across an investible universe of 3,000 CLOs managed by 190 managers1. That could include new issue CLOs, secondary market CLOs, mezzanine debt, and warehouse positions.
By contrast, captive CLO equity funds typically invest exclusively in the next several deals of a single CLO manager. A captive fund participating in four new CLOs would represent a small fraction of the broader CLO market and would be concentrated in transactions managed by a single CLO manager. A public-equity analogue would be a fund that invests only in the next few IPOs underwritten by a single investment bank, irrespective of valuation or business model.
Certain newly issued CLOs in 2025 featured projected equity returns that were materially lower than those available through comparable secondary-market investments. Importantly, CLO managers earn management fees when new CLOs are created, regardless of the projected returns to equity investors. In our view, this structure may create potential incentive misalignment between CLO managers and captive equity fund investors.
The impact of captive equity issuance extends beyond individual CLOs. By supporting CLO formation at suboptimal projected equity returns, we believe that captive funds increase demand for leveraged loans, contributing to tighter loan spreads. At the same time, elevated CLO issuance places upward pressure on CLO financing costs. The combination reduces CLO equity profitability across the market. While captive equity funds are attractive businesses for CLO managers and bankers, their proliferation has weighed on returns for CLO equity investors more broadly.
Captive CLO equity funds are often marketed on the basis of access to a scarce asset — namely, the manager’s own CLOs — and the promise of lower fees. In my experience, truly constrained access to primary CLO equity opportunities is rare. CLO management is fundamentally an assets-under-management business, and broadly syndicated CLO managers typically find ways to accommodate new capital when economic incentives align.
The lower fee argument also warrants scrutiny. While captive funds may advertise discounted CLO management fees, such fees have long been heavily negotiated across the industry, and the broader trend has been downward. It is true that captive equity fund investors avoid the incremental fund-level expenses charged by third-party CLO equity investors. However, those savings come at the cost of limited investable universe and reduced portfolio diversification.
Two questions investors may wish to ask captive CLO equity fund managers are:
- Would the CLO equity recently issued have been attractive to non-captive CLO equity investors?
- If the portfolio were marked-to-market using recent secondary-market trades, what would be the fund’s current fair value?
The word ‘captive’ is defined by the Meriam Webster dictionary as something or someone taken prisoner. In the case of captive equity funds, it’s not clear if the prisoner is the Fund’s investors or the entire CLO market.
Shiloh Bates
CIO, Flat Rock Global
1. Source: Bank of America Global Research, CLO Market Research/Chartbook, Patrik Gupta
This commentary reflects the views of Flat Rock Global as of the date indicated and is subject to change. The information provided is for informational purposes only and does not constitute investment advice of an offer to buy or sell any security. Past performance is not indicative of future results. Investments in CLO equity involve significant risks, including market risk, credit risk, structural risk, and potential loss of principal.
23
Feb
2026
#31, Serhan Secman, Global Head of CLOs, Napier Park
Serhan Secman, Global Head of CLOs at Napier Park, joins The CLO Investor podcast to discuss the CLO investing business, inefficiencies in the market and the three factors that negatively effected CLO equity in 2025.
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10
Feb
2026