Collateralized loan obligations (CLOs) have typically been difficult for retail investors to access. However, CLOs offer potentially significant income and can outperform other fixed income categories on a relative basis. VettaFi recently spoke with William Sokol, VanEck’s director of product management, about the investment argument for CLOs and what the VanEck CLO ETF (CLOI ) can add to a portfolio.
What Exactly Is a Collateralized Loan Obligation?
A collateralized loan obligation, or CLO, is a portfolio of senior secured loans that is securitized and actively managed. Each CLO issues a series of floating rate bonds, along with a first-loss equity tranche. These tranches are all backed by the underlying loans but differ in terms of their seniority, the order they receive principal and interest payments and the degree to which they are insulated from losses in the loan portfolio. As a result, investors can choose the level of risk they want to take. They will achieve returns commensurate with that risk. This structure allows investors to take investment grade risk to a high yield asset class.
Why Invest in CLOs? What Do They Offer Investors?
Historically, CLOs have offered attractive spreads relative to other corporate debt categories. This includes bank loans, high-yield bonds, and investment-grade bonds within the same rating category. Currently, overall yields are at extremely attractive levels relative to other credit asset classes.
CLOs are also floating-rate instruments, meaning they have low sensitivity to changes in interest rates. As interest rates rise or fall, CLO yields will move accordingly, but their prices are relatively stable, all else equal.
These characteristics can be advantageous to investors in diversified fixed income portfolios. In addition, CLOs have built-in risk protection, which has historically helped them experience lower levels of principal loss when compared with corporate debt and other securitized products. This combination of attractive yields and safety, as well as the diversification they provide, make CLOs an attractive addition to a core bond portfolio.
When Do CLOs Tend to Exhibit the Strongest Performance?
CLOs have been one of the best-performing fixed income asset classes over the past decade on a risk-adjusted basis. They have significantly outperformed core bonds on an absolute basis as well based on the broad CLO market benchmark, the J.P. Morgan CLO Index, and the ICE BofA US Broad Market Index. They can perform well in a variety of market environments, particularly relative to other investment grade asset classes, because of the significant spread pickup they provide.
In addition, CLOs have floating rate coupons and therefore are not exposed to interest rate volatility. In 2022, when we saw a significant increase in rates, for example, the asset class had a positive return and outperformed fixed rate investment-grade corporates, measured by the ICE BofA US Corporate Index, by more than 15%. And because the underlying loans drive CLO returns, they can perform very well in strong credit environments as well.
Lastly, even periods of volatility can provide significant opportunity for an active CLO tranche manager to find value and achieve outperformance, particularly if they are able to look through to the underlying loans and identify potential relative value or adjust the ratings exposure in the portfolio to add or reduce risk depending on the market environment. But to do this, you need a broad investment approach, and you need to be active.
Until recently, most investors have not had access to CLOs. This means they may have missed out on this strong performance over the past decade. Fortunately, that’s no longer the case with the launch of CLOI.
Why Did VanEck Go With Active Management for CLOI?
PineBridge Investments, the fund’s sub-advisor, actively manages CLOI.
Replicating the main CLO benchmark is impossible due to the composition of the CLO market and the way CLOs trade. Further, given the tremendous diversity of CLO managers, vintages, underlying exposures and deal terms, there is significant opportunity for an experienced CLO tranche investor to add value.
Active Management a Necessity
Capturing opportunities in the CLO market requires an active approach and the expertise to perform bottom-up research on the individual bank loans in the underlying collateral pool. Some CLOs can have more than 200 issuers in their collateral pool. Accordingly, investment managers must have significant research capabilities to fully evaluate the underlying credit risk in each CLO. In addition, managers need relationships with primary and secondary market desks to efficiently trade and source opportunities.
At the same time, do not underestimate the importance of understanding a CLO’s structural characteristics. Two CLOs with the same exact collateral assets may produce varied performance due to different structural nuances. Additionally, the legal documentation that governs a typical CLO can be in excess of 300 pages. Investors must use due diligence on CLO managers to understand their style and process and to determine whether they are more “debt friendly” or “equity friendly.”
We’re excited to partner with PineBridge on CLOI. They have decades of experience in the CLO market and extensive capabilities in the leveraged finance market. In fact, CLOI is based on a strategy that they’ve managed for institutional clients for many years. Now, that expertise is available to all types of investors through the ETF.
Risk Association With CLOs
The primary risk of investment grade CLOs is spread risk or downgrade risk, but loss of principal from defaults is extremely minimal due to featuring built-in risk protections. The default rate of CLOs is significantly lower than similarly rated corporate bonds and loans. There has never been a AAA default, and in fact, there have only been a handful defaults in BBB and even BB rated CLOs. Those defaults generally occurred in older structures, and risk protections have only increased since the Global Financial Crisis. CLOs provide extremely robust risk protection against credit losses from defaults.
However, because underlying leveraged loans drive returns, movements in the market level of credit spreads cause price impacts. That’s no different from investment grade or high yield corporate bonds. Another risk is the potential for ratings downgrades. If the loan portfolio deteriorates, rating agencies could downgrade a tranche, and the CLO could underperform. That’s why it’s critical to take an active approach and perform due diligence on the portfolio and the CLO manager.
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J.P. Morgan CLO Index is comprised of U.S. dollar denominated arbitrage CLOs of broadly syndicated loans.
ICE BofA US Broad Market (US00) tracks the performance of US dollar denominated investment grade debt publicly issued in the US domestic market, including US Treasury, quasi-government, corporate, securitized and collateralized securities.
ICE BofA US Corporate Index (C0A0) tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market.
This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities, financial instruments or digital assets mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, tax advice, or any call to action. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results, are for illustrative purposes only, are valid as of the date of this communication, and are subject to change without notice.
Actual future performance of any assets or industries mentioned are unknown. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. VanEck does not guarantee the accuracy of third party data. The information herein represents the opinion of the author(s), but not necessarily those of VanEck or its other employees.
An investment in the Fund may be subject to risks which include, but are not limited to, risks related to Collateralized Loan Obligations (CLO), debt securities, LIBOR Replacement, foreign currency, foreign securities, investment focus, newly-issued securities, extended settlement, affiliated fund investment, management and capital preservation, derivatives, cash transactions, market, Sub-Adviser, operational, authorized participant concentration, no guarantee of active trading market, trading issues, fund shares trading, premium/discount, liquidity of fund shares, non-diversified, and seed investor risks, all of which may adversely affect the Fund.
Investments in debt securities may expose the Fund to other risks, such as risks related to liquidity, interest rate, floating rate obligations, credit, call, extension, high yield securities, income, valuation, privately-issued securities, covenant lite loans, default of the underlying asset and CLO manager risks, all of which may impact the Fund’s performance. Derivatives may involve certain costs and risks such as liquidity, interest rate, and the risk that a position could not be closed when most advantageous.
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