Why invest in CLOs? | ETF trends

In the long run, collateralized loan obligation (CLO) tranches have historically performed well relative to other categories of corporate debt, including leveraged loans, high yield bonds and investment grade bonds, and have significantly outperformed at lower ratings levels. CLOs are structured to help mitigate risk, through the strength of their underlying collateral, as well as built-in features such as coverage tests to correct for collateral deterioration. This has historically helped them experience significantly lower levels of principal loss compared to corporate debt and other securitized products. This has resulted in a track record of strong risk-adjusted returns versus other fixed income asset classes, particularly among investment grade CLO tranches.

CLOs track record of strong risk-adjusted returns versus other asset classes

10 years from 31/5/2022

Source: Morningstar. CLOs represented by the JP Morgan CLO Index; AAA-rated CLOs represented by the JP Morgan CLO AAA Index; AA-rated CLOs represented by the JP Morgan CLO AA Index; A rated CLO represented by the JP Morgan CLO A Index; BBB-rated CLOs represented by the JP Morgan CLO BBB Index; BB rated CLOs represented by the JP Morgan CLO BB Index; US IG represented by ICE BofA US Corporate Index; US HY represented by ICE BofA US High Yield Index; Agg is represented by ICE BofAUS Broad Market; US IG FRNs represented by the MVIS US Investment Grade Floating Rate Note Index; Borrowings represented by the S&P/LSTA 100 Leveraged Credit Index. Past performance is not indicative of future results. This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities mentioned herein.

CLOs have been tested through two major crises

Through the global financial crisis and the pullback of COVID-19, the asset class ultimately experienced far fewer defaults than corporate bonds of the same rating. For example, among nearly 17,000 US CLOs issued from 1996-2020 and rated by S&P, only 0.4% experienced default, mostly in non-investment grade tranches. And performance is even better for investment-grade CLOs. In the top-rated AAA and AA CLO tranches, there were zero prepayments. We believe this consistency combined with the potential for positive returns makes the asset class compelling for long-term-minded investors.

The search for income is over

In addition to this strong history of risk-adjusted returns, CLO spreads have historically been significantly wider than those of other debt instruments.

CLOs’ consistent spread acquisition relative to similarly rated bonds*

(In bps as of 31.5.2022)

Spread Pickup from CLOs vs. Bonds: Rated AAA

CLO vs. Bond Spread: Rated AA

Spread Pickup from CLOs vs. Bonds: A Rated

CLO vs. Bond Spread: BBB Rating

Source:* Using option-adjusted spreads for corporate bonds and discount spreads for CLOs. JP Morgan and ICE Data Services. AAA rated CLOs represented by JP Morgan CLO Index AAA, AA rated CLOs represented by JP Morgan CLO AA Index, A rated CLOs represented by JP Morgan CLO A Index, BBB rated CLOs represented by JP Morgan CLO BBB Index, BB Rated by JP CLO represented Morgan CLO BB Index, AAA Rated Corps represented by ICE BofA AAA AAA Index Corporate, AA Rated Corps represented by ICE BofA AA AA Index Corporate, A Rated Corps represented by ICE BofA A US Corporate Index and BBB Rated Corps represented by ICE BofA BBB US Corporate Index. Past performance is not indicative of future results. This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities mentioned herein.

CLOs have lower sensitivity to interest rates

CLOs are also variable rate instruments, meaning they have low sensitivity to changes in interest rates. As interest rates rise or fall, CLO yields will move accordingly, and their prices have historically moved less than those of fixed-rate instruments. These characteristics can be useful for investors in diversified fixed income portfolios.

With higher relative yields, a history of strong risk-adjusted returns and protection against rising rates, we believe there are several benefits to making a strategic allocation to investment-grade CLOs within an income portfolio.

How to invest in CLOs

The CLO market is primarily institutional, with banks, insurance companies and hedge funds often buying CLOs directly or through separate institutional accounts that can hold minimums of $50 million or more. This can make access difficult for many investors.

of VanEck CLO ETF (CLOI) can provide an attractive way for investors to efficiently access this market with the liquidity, transparency and low-cost features of an ETF. CLOI invests primarily in investment grade CLO tranches and may invest up to 20% in BB-rated CLOs, but will not invest in CLOs rated below BB-/Ba3 or in equity tranches of CLOs. The ETF is actively managed by PineBridge Investments, the fund’s sub-adviser.

CLOI aims to provide improved yield by identifying the most attractive segments of the CLO market, avoiding write-downs and default losses. PineBridge can move throughout the CLO capital structure to potentially add alpha, adding risk when possible and de-risking during periods of market volatility.

For more news, information and strategies, visit the Beyond Basic Beta Channel.

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