Treasury yields haven’t been this tasty in decades. That said, collateralized debt obligations (CLOs) are offering yields higher than 6%. Those yields are largely the result of a higher federal funds target rate and resilient consumer spending.
VettaFi contributor Dan Mika spoke with Edwin Wilches, co-head of securitized products at PGIM Fixed Income and portfolio manager for the PGIM AAA CLO ETF (PAAA), on the state of the asset class.
This interview has been edited for clarity and brevity.
Why Invest in CLOs?
Dan Mika, VettaFi: When we’re talking about the overall macro environment, what is the case for CLO exposure in a portfolio?
Edwin Wilches, PGIM: When we talk CLOs, it’s important to remember that CLOs are a fairly broad asset class with well over a trillion dollars in assets at this point. When we’re talking about the case, we are really talking about the case for AAA-rated CLOs. You have everything from AAA, which are the least-risky securities, down to BBs, and then there’s equity. I want to be clear, the best opportunity today is really the AAA part of the market.
I think the case is actually quite simple. In yesteryears when investors needed yield, they both needed to either go out in duration or go down in credit. Given the inverted yield curve and where we’re at in the market, investors today can actually benefit quite a bit from being shorter in duration and high in quality.
A Positive Outlook
The market has given investors the opportunity here to pick up a lot of yield in what we consider a fairly fundamentally sound and big part of the CLO capital structure. We largely expect the Fed to [hold steady] for some time, so for these securities in general, we’re looking at the spread to be anywhere between 175 to 200 basis points. And we’re seeing SOFR effectively following the Fed funds rate at close to 5.5%. You’re probably getting yields that are close to or over 7%. For us, that’s a very attractive option for investors.
I don’t think we would ever suggest it’s the only option. However, it’s pretty interesting how the CLO market is accessible now… These securities we expect should perform relatively well. They have protection due to where they sit in the capital structure and getting the highest priority. Any credit losses that are seen in the underlying asset wouldn’t be sufficient for these securities to be impaired.
The Argument for AAA-Rated CLOs
VettaFi: You already touched on the credit advantage that triple AAA securities have. Can you talk a little bit more about why PGIM is favoring those? There are BBB-rated CLO ETFs out there that are still investment-grade and offer an SEC yield that’s almost 2% higher in exchange for that higher risk, but still being investment-grade. Walk me through why it would make sense in the current environment to be conservative on credit quality.
Wilches: From our perspective, we think of the trade-off between being in the most integral part of the capital structure where we really don’t have exposure to economic uncertainty or economic downturn while still earning a very high spread or yield is incredibly attractive.
As you start going down the path of that structure, and even just looking at historical analysis, we see that when there are concerns about the underlying assets, those securities do tend to break down quite a bit, in large part because they have credit exposure and sensitivity.
Historically, we haven’t seen much — if any — losses in those tranches… So we’re not suggesting these securities will take impairments or significant losses. But for us, being up in the capital structure and having a really attractive yield and spread, we would argue that we’re being overcompensated for the risk that we’re taking.
Whereas when we look at some of the BBBs, there are some opportunities, but I would say by and large, we would expect investors to demand a little more of a premium than what’s currently on offer because those securities are more sensitive to credit risk. Internally when we’re looking at the credit of these securities, many of those BBBs would not be rated investment-grade from our end.
The Fed’s Effect
VettaFi: How do you see the current Fed regime and market dynamics in Treasuries playing into the CLO space? The Fed has signaled higher rates for longer. In recent months, we’ve seen the long end of the Treasury curve steepen up to the one-year yield. How does all of this play into what you’re seeing in CLOs and the future of these products?
Wilches: It’s been a tailwind for CLOs whenever there was concern around the economy or other things when we had the zero interest rate policy. That meant that although these products had attractive spreads, and from an institutional perspective, we’ve liked CLOs for a long time. We’re one of the larger asset managers… . We’ve been doing this for a really long time.
We have seen a lot more retail products like ETFs come into the market, and that’s been a tailwind. We all know interest rate policies and monetary policy work in lags, so I think as investors, we’re looking at how the underlying assets (of the CLOs) are constructed.
Some Will Struggle
The good news is investors are getting more deals, and this is true for CLOs and the bank loan market. The bad news is that interest expenses for companies have also gone up along with rates on floating rate issuers. They can pass along some of those additional interest expenses to end consumers. Or they can absorb some through corporate margins. We do feel many companies or at least a larger percentage than expected will struggle with this.
Ultimately, we believe that the Fed is getting back to normal in terms of rates. Zero percent wasn’t normal, historically speaking, which also means that we will see likely more defaults in the next coming quarters. For AAA CLOs, that won’t have a material impact. However, other parts of the CLO market, particularly down the cap structure, meaning equity, double-B, and triple-B could be much noisier. Fed policy is helpful from a yield perspective – however longer term we are looking at consequences on underlying assets and their ability to continue paying.
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