CLOs and Monetary Policy Transmission

Robert Reynolds
5th August 2026

Educational Content

Collateralised Loan Obligations

Introduction

CLOs are floating rate products, which means that both assets and liabilities are linked to prevailing market rates (benchmark interest rates). This is one of the matching principles that underpins the CLO model (see CLO Insights – CLOs for All Seasons) and serves to reduce duration risk.

This feature also has an incidental role as part of the monetary transmission mechanism — the process through which central bank policy decisions feed through the financial system and affect output, inflation and employment in the real economy.

The Role Of Central Banks

One of the primary jobs of a central bank is to manage the level of inflation by controlling the money supply. It does this through monetary policy, including setting benchmark interest rates.

Central banks typically target a low inflation rate (around 2%) because:

it helps to create a stable economy which is good for investment, employment and growth;
it reduces the risk of deflation; and
it provides a buffer to influence the economy
through interest rate changes.

The Interest Rate Channel

Lowering interest rates makes borrowing cheaper and gives people more disposable income (because mortgage and loan repayments fall). It also makes savings less attractive since deposit returns are lower. Together, this encourages people to spend rather than save. Cheaper money also encourages businesses to invest and hire more workers, stimulating employment and economic growth.

However, if demand for goods and services increases faster than supply can keep up, businesses may raise prices – leading to higher inflation. Conversely, raising interest rates increases borrowing costs, reduces disposable income and encourages saving as deposit rates rise. Higher financing costs also lead businesses to cut back on investment and hiring as a result. All of this dampens economic activity and slows the pace of price increases, helping to bring inflation under control.

Rigidities

The challenge with using interest rates as a policy tool is that changes to benchmark interest rates do not immediately or evenly flow through to all parts of the economy. Because of this, there has been renewed debate among economists about whether the monetary transmission mechanism is impaired.

Bank balance sheet constraints, fixed rate mortgage structures and sticky lending margins are all slowing the pass-through. Economists refer to “rigidities” in the transmission system. For example, retail borrowing rates and credit card rates are not directly linked to benchmark rates. Certain borrowers may also have chosen to fix their mortgage rates for a set period, insulating them from rate changes in the short term.

Similarly, businesses that have issued fixed rate bonds will not see their borrowing costs change until those bonds mature and are refinanced. Lenders may also choose not to pass on the full rate
change to their customers depending on their own competitive or financial position.

As a result, some economists estimate that interest rate changes can take between 6 and 24 months to have their full impact. This is like applying the brakes of your car in January and only starting to slow down in July. Or pressing the accelerator and travelling at the same speed for another 10,000 miles. There is also some potential asymmetry here, as banks tend to pass on rate increases to borrowers relatively quickly (since it improves their margins) but are slower to pass on rate cuts. It’s therefore easier for Central Banks to “tighten” policy rather than “loosen” it.

Where do CLOs Fit In?

European corporate loans held by CLOs are mostly linked to the European Interbank Offered Rate (Euribor) which is the rate that banks lend to each other on an unsecured basis. Euribor closely tracks the European Central Bank’s (ECB) benchmark rate, albeit typically with a small premium that reflects interbank credit risk.

CLOs pass through interest rate changes quickly and directly. This is because borrowing costs and investor returns are linked to floating rates, so when benchmark rates move CLOs adjust accordingly at the next interest reset date.

The size of the European CLO market is ca.€300 billion. This means that a 1% change in benchmark rates equates to ca.€3 billion p.a. impact on European CLO investors and underlying borrowers.[1] Given this scale, CLOs are a meaningful route through which Central Bank rate decisions reach the corporate sector.

The Expectations Channel

Central banks often explain their reasoning publicly. They also give indications of their thinking for the future to try to manage expectations. This is known as “forward guidance” and is intended to help markets and businesses to plan, by reducing uncertainty about the direction of policy.

Borrower Behaviour

Borrowers can choose when to pay interest on their loans at 1-, 3-, 6-or 12-month intervals (known as “interest periods”). At the start of each interest period, the applicable Euribor rate for that tenor is fixed for the duration of the period. For example, a borrower that chooses a 3-month interest period will have its base borrowing rate set by reference to the 3-month Euribor rate.

Using this flexibility, borrowers can manage the timing of their interest payments. They can also manage the cost by anticipating future interest rate movements based on forward guidance. For example, if they think that rates are going up, they will choose a longer interest period to lock in the current lower rate for a longer period. This delays the impact of higher rates.

On the other hand, if borrowers expect rates to fall, they will tend to opt for a shorter interest period in the hope that when the loan rolls over to its next interest period, the prevailing Euribor rate will be lower — allowing them to benefit from the cut sooner.

The net effect of this is to speed up the transmission of rate cuts and slow down the transmission of rate increases. This provides a useful counterbalance to the asymmetry in bank pass-through behaviours, noted earlier and although incidental it also helps monetary policy to operate more effectively in the leveraged loan market.

Conclusion

CLO’s floating rate structure and the growing size of the market (see forthcoming “CLO Insights – The Market”) means that CLOs can have a meaningful role to play in the implementation of monetary policy to the real economy. They provide a direct and relatively frictionless channel through which central bank rate decisions flow through to corporate borrowers.

In periods where the transmission mechanism is under strain, such as due to constrained bank balance sheets, CLOs represent one of the more reliable conduits through which policy rate changes reach corporate borrowers.