CLOs: An Institutional Strategy for the Masses

ETFs continue to open up avenues of opportunity for individual investors by capturing institutional investor strategies in an easily, widely accessible wrapper. One such strategy, that of collateralized loan obligations (CLOs), offers investors attractive income and yield with lower default risk.

In a panel on CLOs moderated by Tom Lydon, vice chairman of VettaFi, at the VettaFi Fixed Income Symposium, Danielle Gilbert of Panagram and Fran Rodilosso of VanEck explained the institutional strategy as well as the benefits for investors.

The Basics of CLOs

Attendees were asked about how they’re planning to balance duration and credit risk in the next 12 months. 57% of respondents indicated that they planned to take on more duration and less credit risk.

A great way to do that is through collateralized loan obligations (CLOs). But what exactly are CLOs? Danielle Gilbert, managing director at Panagram, drilled down into the basics of the institutional strategy that makes up a $1 trillion market.

“These are floating-rate bonds that derive their value from a pool of senior secured loans,” Gilbert explained. The underlying bonds have ratings anywhere from AAA to BB and are highly diversified. Pools constitute anywhere from 150-300 individual loans across a range of industries, with mechanisms in place to prevent single-sector concentration.

Payments are structured in what’s called a “waterfall” so that AAA-rated loans are paid first and BB loans last. The historical recovery rate is 70 for these loans, although that could dip in the current environment. Gilbert was quick to remind investors that these loans are senior loans that sit at the very top of a corporation’s balance sheet.

CLOs are “a good place to be in the current environment,” said Gilbert. “The fact that these are floating-rate and you have that additional credit spread — it’s really earning a very attractive income wherever you are up and down that corporate capital structure.”

Fran Rodilosso, head of fixed income ETF portfolio management at VanEck, also noted the collateralizations of CLOs as one of their most foundational and attractive qualities.

Understanding CLO Risk

Rodilosso noted that one of the foundational aspects of CLOs is the collateralization.

“These are large, liquid loans, usually from fairly well-known borrowers. They are very analyzable,” Rodilosso explained. It’s this transparency and ability to analyze the underlying loans that make them significantly less risky than past iterations.

The loans are also actively managed. It’s a key difference from collateralized debt obligations (CDOs), which collapsed spectacularly and led to the Great Financial Crisis. Whereas CDOs comprised a pool of thousands of loans, CLOs are made up of a few hundred with active oversight. CLOs have also become a high-quality investment option, particularly in recent years. They’ve been around for nearly three decades and continue to have safety mechanisms and oversight built into them

When it comes to default risk and default rates, CLOs historically hold very small default risk. Between 1996-2021, the S&P-rated AAA tranches, comprised of more than 6,000 tranches, yielded zero defaults.

A chart of annual global default rates of CLOs versus corporations between 2001-2021. CLOs hover near 0.

Image source: VanEck

Yield Opportunities Abound This Year

Because of their floating-rate nature, CLOs benefited from rising rates this year. “I think it’s an incredible opportunity to get active income yield without reaching for credit risk,” said Gilbert.

But how does the yield of a CLO stack up right now against investment-grade corporate bonds? Turns out, pretty spectacularly.

“An AAA CLO tranche today has a yield pickup over BBB investment-grade corporate bond,” Rodilosso explained. While investing in a CLO doesn’t add duration to a portfolio, it does add yield.

In an environment where interest rates are likely to remain high, CLOs offer a number of potential benefits to portfolios. The accessibility of the strategy through ETFs opens up CLOs to individual investors. What’s more, the benefits of ETFs and the inherent liquidity they provide mean that a number of institutional investors now access the strategy through ETFs.

“Core bond fixed income portfolios, the top 10 if you look at Morningstar… 60% are allocating to CLOs,” Gilbert explained. “Investors might already have access and not realize this, but what’s great about the ETF, as everybody knows here, is you have choice now.”

Panagram offers the Panagram BBB-B CLO ETF (CLOZ) and the Panagram AAA CLO ETF (CLOX) for investors seeking more targeted CLO tranche exposure. VanEck offers the VanEck CLO ETF (CLOI). Briefly touched on was also the VanEck Fallen Angel High Yield Bond ETF (ANGL).

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