By William Sokol
Director of Product Management
Over the past several years, CLOs within a core bond portfolio would have provided additional yield—without adding duration—as well as increased returns and lower volatility.
Why do so many active core bond managers invest in collateralized loan obligations (CLOs)? Of the top 20 mutual funds in Morningstar’s Intermediate Core Bond and Intermediate Core-Plus Bond categories, representing approximately $750B of assets, all but three had allocations to CLOs.1 This is notable given that traditional U.S. “aggregate” bond indices, which represent the broad investment grade investment universe, do not generally include CLOs. Approximately 93% of core bond funds are benchmarked to an aggregate index, which begs the question: why are so many of these managers investing off-benchmark?
We believe the answer is obvious: CLOs may result in better investment outcomes to core bond investors. Based on historical asset class returns, this would have been the case over the past several years, as shown below. CLOs can add additional yield without added interest rate duration, and historically increased returns and lowered volatility relative to an agg-only index—and accordingly enhanced risk adjusted returns as measured by the Sharpe ratio.
CLOs Have Boosted Core Bond Returns
|YTD||1 Yr||3 Yrs||5 Yrs||7 Yrs||Since
|100% US Agg||3.01||-8.63||-2.45||0.86||1.12||1.43||4.42||0.12|
|90% US Agg + 10% CLO||2.87||-7.64||-1.98||1.06||1.37||1.59||4.08||0.17|
|75% US Agg + 25% CLO||2.66||-6.15||-1.27||1.36||1.74||1.83||3.65||0.24|
Source: J.P. Morgan and Morningstar Direct, as of 1/31/2023. CLOs represented by the J.P. Morgan CLO Index; US Agg is represented by ICE BofA US Broad Market Index.
Last year, blending an agg-only index with some portion of CLO returns would have been particularly impactful. For example, a blended benchmark of 25% CLOs, as measured by the J.P. Morgan CLO Index, and 75% core bonds, as measured by the ICE BofA US Broad Market Index, would have increased returns by over 300 basis points relative to 100% core bonds. A 50% / 50% blend would have increased returns by over 650 basis points versus core bonds. Although such a high portion of CLOs is likely unrealistic for many bond investors benchmarked to the agg, this example illustrates the return potential of a tactical overweight in a difficult year such as 2022.
The benefits that CLOs provide in a core bond portfolio are straightforward: yield, quality and diversification. Yields on CLOs are particularly attractive now and significantly above long-term averages and what can be found in other fixed income asset classes. For example, CLOs, on average, provided a yield-to-worst of 6.49% on 1/31/2023, compared to 4.33% on the agg and 5.05% on U.S. corporate bonds.2
Higher Yield Without Added Interest Rate Duration
Source: J.P. Morgan and ICE Data Indices, as of 1/31/2023. CLOs represented by the J.P. Morgan CLO Index; US Agg is represented by ICE BofA US Broad Market Index.
These high yields are driven by a few factors. For one, short-term rates have risen significantly over the past year as the Federal Reserve continues its current rate hiking cycle. Because CLOs are floating rate, this is reflected in higher coupons. The Fed has indicated that additional hikes are on the way, and although the market appears to doubt the Fed’s resolve to maintain high rates for at least the rest of the year, we generally take the Fed at its word and believe that bond investors should be wary of “fighting the Fed.”
Yields on CLOs are also high because of the spread over the risk-free rate that they provide. CLOs have always provided a spread pickup versus similarly rated bonds and loans, but right now that pickup is particularly compelling relative to historical averages. That suggests that a certain degree of risk is being reflected in CLOs prices currently. Given the possibility of weaker corporate earnings and economic growth ahead, we believe this makes CLOs attractive relative to other credit asset classes, such as high yield bonds, where spreads have remained tight versus historical averages.
From a quality perspective, investment grade CLOs do not require a core bond investor to take additional credit risk. The risk of default in senior CLO tranches is extremely low given the many built-in risk protections they offer, such as high levels of subordination. As a result, defaults in the underlying portfolios need to be multiples greater than historical averages for several years in a row to experience a default, even in lower rated investment grade CLO tranches. And CLOs may diversify a core bond portfolio in several ways. First, the floating rate exposure makes them less sensitive to changes in interest rates, and therefore they exhibit low correlation to fixed rate bonds, with a 5-year correlation to core bonds of only 0.25.3 Second, because CLOs are backed by portfolios of senior secured leveraged loans, the credit exposure is different from the investment grade corporate borrowers that have significant presence in agg benchmarks.
CLOs have historically only been available to large institutional investors such as banks, insurance companies, and asset managers. While active core bond fund managers have used CLOs for many years to potentially beat their benchmark, investors now have the ability to access this $1.2T market directly. We believe that investors should invest beyond AAA CLOs and utilize the full investment grade portion of the CLO capital structure to capture the benefits that this asset class may provide in a core bond portfolio.
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Originally published by VanEck on February 23, 2023.
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1 Source: Morningstar Direct.
2 Source: J.P. Morgan and ICE Data Indices. CLOs represented by the J.P. Morgan CLO Index; Agg bonds represented by ICE BofA US Broad Market Index; US corporates represented by ICE BofA US Corporate Index.
3 Source: Morningstar, as of 1/31/2023. Core bonds represented by the ICE BofA US Broad Market Index.
J.P. Morgan CLO Index tracks US dollar denominated broadly-syndicated, arbitrage CLOs.
ICE BofA US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market.
ICE BofA US Broad Market 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.
Please note that VanEck may offer investments products that invest in the asset class(es) or industries included herein.
This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. 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. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.
An investment in a Collateralized Loan Obligation (CLO) may be subject to risks which include, among others, debt securities, LIBOR Replacement, foreign currency, foreign securities, investment focus, newly-issued securities, extended settlement, management, derivatives, cash transactions, market, operational, trading issues, and non-diversified risks. CLOs may also be subject 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 adversely affect the value of the investment.
All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future results.
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