An Alternative Fixed-Income ETF Idea to Limit Rate Risk, Generate Yields | ETF Trends

As we consider the current market environment, fixed-income investors can turn to collateralized loan obligations, or CLOs, exchange traded fund strategies to diversify their portfolios.

In the recent webcast, CLOs: Lower Duration Risk and Pick Up Yield, Fran Rodilosso, head of fixed income ETF portfolio management at VanEck, underscored the potential protection that CLOs offer against a rising interest rate environment. Rodilosso explained that CLO coupons adjust based on a reference rate (SOFR/LIBOR) and therefore have lower duration risk versus similarly rated fixed income alternatives. Additionally, the floating rate coupons may make CLOs potentially attractive in an environment of elevated inflation, such as the one we are currently experiencing.

William Sokol, director of ETF product management at VanEck, also noted that this is not some fringe or niche market segment as CLOs are an integral part of the global financial market, making up a $1 trillion market. CLOs are not a niche asset class as they have gained widespread institutional adoption. The global CLO market reached the $1 trillion benchmark size in mid-summer 2021. Meanwhile, the total principal outstanding was $875 billion for U.S. CLOs and €187 billion for European CLOs. U.S. CLOs even represent 63% of the total U.S. leveraged loan market.

Laila Kollmorgen, portfolio manager, CLO Tranche at PineBridge Investments, explained that CLOs are a securitized pool of senior secured loans. Specifically, CLOs hold floating-rate, secured loans which have seniority over other claimants in the event of insolvency. Assets are financed by multiple tranches of debt with different seniorities and an equity tranche. Cash flows from the loan portfolio are paid sequentially starting with the most senior tranche.

Moreover, risk-averse investors may like to know that CLOs benefit from multiple structural protections or built-in risk protections. Kollmorgen added that CLO managers analyze issuers and apply sector expertise to construct portfolios, with fees generally linked to performance. Subordinated tranches absorb losses first. CLOs also have features that are protective of debt tranches. Lastly, excess income compared to interest paid on debt tranches protects in case coverage tests are not met, which can be used to buy additional assets or pay down notes.

Kollmorgen contended that relative to other structured products, CLOs are significantly more resilient, such as what we have witnessed during the Global Financial Crisis. CLOs also come with relatively low default rates, with annual global default rates of just 1.7% for the riskiest BB-rated CLOs.

When comparing risk profiles, Sokol pointed out that CLOs also offer attractive long-term risk-adjusted returns, as represented by a higher Sharpe Ratio, compared to other asset classes. Specifically, the historical 10-year Sharpe Ratio of CLOs was 0.69, compared to a lower 0.28 for the benchmark U.S. Aggregate Bond Index, or so-called Agg.

To help investors access the CLOs market, VanEck recently launched the VanEck CLO ETF (CLOI), which is sub-advised by PineBridge Investments.

Looking at PineBridge’s CLO tranche investment philosophy, Kollmorgen explained that they manage downgrade/default risk of a CLO tranche, monitor CLO-specific metrics for early warning of credit deterioration, utilize the entire capital stack in a CLO to add alpha during periods of volatility, and utilize PineBridge specialists to inform top-down positioning. The PineBridge process includes CLO manager due diligence, re-underwrite CLOs, construction of a portfolio, and ongoing risk monitoring.

CLOI offers a “portfolio of investment grade floating rate CLOs with limited exposure to rising rates,” and “yield pickup versus similarly rated corporate bonds and loans with built-in protection against credit loss,” according to VanEck.

Financial advisors who are interested in learning more about CLOs can watch the webcast here on demand