By William Sokol
Director of Product Management
One of the most frequently asked questions we receive from investors new to collateralized loan obligations (CLOs) is whether their higher yield and spread profile with near-zero default risk is “too good to be true.” How is this risk/return profile, which has driven the most attractive risk-adjusted returns in fixed income over the past decade, possible? There are several factors that help explain this:
- High yielding collateral: CLOs are backed by a pool of leveraged loans, which are non-investment grade and produce high levels of income that gets distributed to CLO tranche investors. As of February 29, 2024, leveraged loans yielded 9.2% versus 5.5% on investment grade (IG) corporate bonds.
- Structural protections: Each tranche of a CLO has varying degrees of subordination, which insulates investors from default losses. 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. The average CLO portfolio would need to experience default rates several multiples of the historical average, for 5 or more consecutive years, for the first dollar of loss even in BBB and BB rated tranches. There has never been a default in AAA rated CLOs.
Extreme Levels of Defaults Would Be Needed to Impair A CLO Tranche
Source: PineBridge Investments. For illustrative purposes only. Past performance is not indicative of future results. This is not an offer to buy or sell, or recommendation to buy or sell any of the securities mentioned herein.
- CLO market structure: CLOs are not homogenous (even those with the same rating are not one in the same) and require extensive due diligence before investing, introducing a risk premium. Every portfolio is different in terms of underlying issuers, sectors and vintages. Deal documentation can vary, as well as CLO manager style. These differences highlight the need for active management by an experienced CLO tranche portfolio management team. Further, each tranche has a unique investor base with different return targets, which can drive yields higher. For example, banks are the biggest investors in AAA CLOs, and a CLO cannot be issued without placing the AAA tranche. Accordingly, changes to bank capital requirements recan have an outsized impact on AAA CLO spread levels. Lastly, non-institutional investors have not had access to the asset class until recently with the advent of CLO ETFs.
After walking through these points, the follow-up question is often “if that’s true, what can go wrong?” Although default risk is not the primary risk of CLO tranche investing, CLO tranche investing is not risk-free. 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. And like any credit investment, wider spreads will impact market values. March 2020 provides a recent example of how CLOs perform versus other corporate asset classes in a tail-risk scenario (see exhibit).
CLOs Fared Much Better than High Yield and Leveraged Loans During the Covid-Fueled Sell-Off in March 2020
Source: ICE Data Indices, Morningstar. Drawdown is the largest drop from a peak to a bottom from March 1, 2020 to March 30, 2020. CLOs represented by J.P. Morgan CLO Index; HY Corporates represented by ICE BofA High Yield Index; US Treasuries represented by ICE BofA US Treasury Index; IG Corporates represented by ICE BofA US Corporate Bond Index; Leveraged Loans represented by Morningstar LSTA US Leveraged Loan 100 Index. Index performance is not representative of Fund performance. It is not possible to invest directly in an index.
CLOs, in aggregate (i.e. from AAA to BB rated tranches) experienced a drawdown similar to investment grade corporate bonds during the COVID selloff. 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.
Conclusion
CLOs have had a compelling run over the past decade, especially when compared to their fixed income peers. Like all investments – CLOs are not risk free, and tail risks, like the March 2020 Covid sell-off, do occur. But, even in that scenario, CLOs performed in line with investment grade corporate bonds, and better than high yield bonds and leveraged loans. We believe this resilience illustrates that, rather than being “too good to be true,” the structural features of CLOs and the CLO market explain why this asset class has been able to perform so well.
VanEck has partnered with PineBridge Investments on the VanEck CLO ETF (CLOI), which provides access to investment grade floating-rate CLOs. CLOI benefits from PineBridge’s decades of CLO market experience, both as a CLO manager and CLO tranche investor, and deep leveraged finance expertise.
Originally published by VanEck on March 15, 2024.
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DISCLOSURES
Index Descriptions:
ICE BofA U.S. Corporate Index tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market.
ICE BofA U.S. High Yield Index tracks the performance of U.S. dollar-denominated below investment grade corporate debt publically issued in the U.S. domestic market.
ICE BofA U.S. Broad Market tracks the performance of U.S. dollar denominated investment grade debt publicly issued in the U.S. domestic market, including US Treasury, quasi-government, corporate, securitized and collateralized securities.
ICE BofA U.S. Treasury Index tracks the performance of U.S. dollar denominated sovereign debt publicly issued by the U.S. government in its domestic market.
J.P. Morgan Collateralized Loan Obligation Index tracks U.S. dollar denominated broadly-syndicated, arbitrage CLOs.
Morningstar LSTA U.S. Leveraged Loan 100 Index seeks to mirror the market-weighted performance of the largest institutional leveraged loans as determined by criteria based upon market weightings, spreads, and interest payments.
This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities, financial instruments or digital assets mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, tax advice, or any call to action. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results, are for illustrative purposes only, are valid as of the date of this communication, and are subject to change without notice. Actual future performance of any assets or industries mentioned are unknown. 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. VanEck does not guarantee the accuracy of third party data. The information herein represents the opinion of the speaker(s), but not necessarily those of VanEck or its other employees.
The Fund’s benchmark is the JP Morgan CLOIE Index which is the first rules-based total return benchmark for broadly-syndicated, arbitrage US CLO debt. Information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The Index is used with permission. The index may not be copied, used or distributed without J.P. Morgan’s written approval. © 2024, J.P. Morgan Chase & Co. All rights reserved. Index performance is not representative of Fund performance. It is not possible to invest directly in an index.
An investment in the VanEck CLO ETF (CLOI) may be subject to risks which include, but are not limited to, risks related to Collateralized Loan Obligations (CLO), debt securities, LIBOR Replacement, foreign currency, foreign securities, investment focus, newly-issued securities, extended settlement, affiliated fund investment, management and capital preservation, derivatives, cash transactions, market, Sub-Adviser, operational, authorized participant concentration, no guarantee of active trading market, trading issues, fund shares trading, premium/discount, liquidity of fund shares, non-diversified, and seed investor risks, all of which may adversely affect the Fund. Investments in debt securities may expose the Fund to other risks, such as risks related 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 impact the Fund’s performance. Derivatives may involve certain costs and risks such as liquidity, interest rate, and the risk that a position could not be closed when most advantageous.
Investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider the investment objective, risks, charges and expenses of the Funds carefully before investing. To obtain a prospectus and summary prospectus, which contain this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus carefully before investing.
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