For the uninitiated, collateralized loan obligations (CLOs) may appear too good to be true. This corner of the bond market offers tempting yields, usually well in excess of aggregate bond strategies, with relatively low credit risk.
Usually, investors have to make a trade-off, exchanging yield for credit quality. With CLOs, that’s often not the case and thanks to exchange traded funds such as the new VanEck AA-BB CLO ETF (CLOB ), CLOs are more accessible for a broader swath of income investors.
The actively managed CLOB debuted last month and is the stablemate of the successful VanEck CLO ETF (CLOI ). In the case of CLOB, the rookie ETF focuses on CLO opportunities outside the AAA-rated realm, which is a point of emphasis for CLOI. While CLOB stretches outside of the AAA CLO sphere, it doesn’t subject investors to significant credit risk, but it can deliver yield in excess of investment-grade corporate bonds.
Why CLOB Matters Now
CLOB is a new kid on the ETF block, but that doesn’t diminish its advantages, which include its status as an actively managed fund.
“Active management, collateral requirements, and overcollateralization provide additional protection. Combined with the lower loss rates on senior secured loans relative to high yield bonds, the risk of default in investment grade CLO tranches is negligible,” noted William Sokol, VanEck director of product management.
Active management is potentially advantageous when it comes to CLOs because even with the advantages inherent with this asset class, it’s not 100% free of risk. For example, CLOs, like other bonds can be vulnerable to downgrades.
“In particular, spread and downgrade risk need to be carefully monitored. Deterioration in the underlying loan market can result in downgrades of CLO tranches, which can drive prices lower,” added Sokol.
Another potential advantage offered by CLOB is the durability of CLOs during turbulent market settings. Indeed, past performance isn’t a guarantee of future returns, but CLOs’ steadiness during periods of elevated volatility is noteworthy. For example, CLOs stood tall relative to junk bonds and leveraged loans during the coronavirus bear market of 2020.
“High yield bonds and leveraged loans fared much worse. In addition, CLOs fully recovered by August 2020 and did not experience a spike in defaults. So, CLOs are clearly not free from market risk, but an allocation did not add more downside risk versus other credit sectors in this extreme volatility, even with exposure to CLOs rated below AAA,” concluded Sokol.
Editor’s note: Advisors interested in learning more about CLOs and ETFs such as CLOB and CLOI can attend VettaFi’s Fixed Income Symposium on Oct. 24. VanEck’s William Sokol will be one of the guest speakers. Registration is available here.
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