By William Sokol
Director of Product Management
Don’t mistake CLOs for CDOs—CLOs invest in senior secured loans and have built-in risk protections that have been tested through two major market crises.
Collateralized loan obligations (CLOs) are not the same thing as collateralized debt obligations (CDOs). While they both securitized products that, on the surface, share many structural similarities, these similarities and the terminologies used can cause confusion among investors, who may end up conflating CLOs with some of the more notorious CDOs of the past. As a result, the perception exists among some investors that all structured credit is inherently riskier than more traditional fixed income. However, CLOs stand apart from other types of structured credit due to the types of assets they invest in and structural risk protections. This has resulted in stark performance differences historically, including during and after the 2008 Global Financial Crisis (GFC), in which CLO investors (particularly those in senior tranches) fared very well, while many CDO investors experienced severe losses.
In this blog, we dispel prevailing misconceptions around CLOs, and highlight their relative stability, even in periods of extreme stress like the 2008 Global Financial Crisis and the more recent COVID-19 market drawdown.
As a generic term, CDO can refer to vehicles that hold a variety of debt instruments including bonds, mortgages (including subprime mortgages) or even other CDOs. CLO refers to vehicles that invest in leveraged loans. Ultimately, this is the most important differentiator between CLOs and CDOs, and it drives the vastly different risk and return profiles. Leveraged loans are a form of corporate debt, like high yield bonds, often issued by household names such as American Airlines, Staples and Charter Communications. However, leveraged loans rank senior to high yield bonds and have a first lien on the company’s assets, resulting in higher recovery rates, and thus lower loss rates, historically compared to lower ranking and typically unsecured high yield bonds. Ultimately, this means lower credit risk, all else equal.
The focus of CLOs on corporate credit is worth emphasizing, particularly as concerns in the real estate market emerge. Although there is a type of CLO that invests in real estate loans (CRE CLOs), these are distinct from the $1 trillion CLO market that invests in broadly syndicated leveraged loans. In general, CLOs also have very low indirect real estate exposure as well (e.g. to regional banks or REITs).
A CLO typically holds 150-250 individual loans. CLOs are generally more transparent than CDOs, allowing investors to look through to the underlying loans. An experienced CLO tranche investor can therefore perform credit analysis on the underlying issuers to inform their buy or sell decisions. This is in contrast to CDOs that held subprime mortgages, which provided portfolio-level statistics of the underlying borrowers, but little detail on the thousands of underlying mortgages. The leverage loan market itself is regulated, in addition to the borrowers themselves being widely covered by credit analysts, whereas the subprime mortgages held in GFC-era CDOs were lightly regulated and were not subject to rigorous due diligence. These CDOs also did not benefit from a long history of corporate default and recovery data on which to base pricing and ratings assumptions, as the subprime mortgage and credit derivative market were relatively new and had not experienced a market environment anything like the GFC.
The underlying loans of a CLO are liquid and tradeable, which is not the case with other CDOs. CLOs are also actively managed, and for a period of time after issuance, the collateral manager can actively trade and reinvest within the loan portfolio. This active management is a key risk mitigator for CLOs, allowing CLO managers to maintain the overall credit quality of the portfolio by selecting loans with attractive characteristics, or reducing or avoiding issuers or sector exposures they are less comfortable with.
CLOs Did Not Cause the 2008 Global Financial Crisis
One common misperception is that CLOs are excessively risky and contributed significantly to the 2008 Global Financial Crisis. This confusion arises because of their similarity with CDOs in terms of structure and nomenclature, and the latter’s notorious reputation for being a major contributor to the crisis. In fact, not only did CLOs have nothing to do with the Global Financial Crisis, the asset class thrived through the 2008 crisis relative to other fixed income asset classes.
Through both the Global Financial Crisis and COVID-19 drawdown, CLOs ultimately experienced fewer defaults than corporate bonds of the same rating. For example, of the approximately $500B of U.S. CLOs issued from 1994-2009 and rated by S&P, only 0.88% experienced defaults. In the higher rated AAA and AA CLO tranches, there have been zero defaults.1
CLOs Are Built Different—With Built-In Risk Protection
In addition to the attractive risk profile and active management of its underlying collateral, the structure of CLOs helps mitigate risk. For example, coverage tests are a vital mechanism to detect and correct collateral deterioration, which directly affects the allocation of cash flows. All CLOs have covenants that require the manager to test the portfolio’s ability to cover its interest payments monthly. Among the many such tests, the most common are the interest coverage and overcollateralization tests. Interest coverage dictates that the income generated by the underlying pool of loans must be greater than the interest due on the outstanding debt in the CLO, while overcollateralization requires the principal amount of the underlying pool of loans to be greater than the principal amount of outstanding CLO tranches. As shown below, if the tests come up short, cash flows are diverted from more junior tranches to pay off the most senior tranches first, until these failures are cured.
CLOs Are Structured to Protect Debtholders
Source: VanEck. This is not an offer to buy or sell, or recommendation to buy or sell any of the securities mentioned herein.
The Reality of CLOs: Strong Historical Performance
Don’t let prevailing misconceptions about CLOs deter you from considering this asset class as part of a diversified portfolio. Understanding the intricacies of these securities can potentially uncover valuable investment opportunities often overshadowed by misunderstandings.
Over the long term, CLO tranches have performed well relative to other corporate debt categories, including leveraged loans, high yield bonds, and investment grade bonds, and have significantly outperformed at lower rating tiers. Because of CLOs’ built in risk protection—which comes from the strength of their underlying collateral as well as structural traits, such as coverage tests to correct collateral deterioration—they have historically experienced lower levels of principal loss when compared with corporate debt and other securitized products. This has resulted in a track record of strong risk-adjusted returns versus other fixed income asset classes.
CLOs versus Other Asset Classes
Source: Morningstar. CLOs represented by J.P. Morgan CLO Index; AAA Rated CLOs represented by J.P. Morgan CLO AAA Index, AA Rated CLOs represented by J.P. Morgan CLO AA Index, A Rated CLOs represented by J.P. Morgan CLO A Index, BBB Rated CLOs represented by J.P. Morgan CLO BBB Index, BB Rated CLOs represented by J.P. 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 the ICE BofA US Broad Market, US IG FRNs represented by MVIS US Investment Grade Floating Rate Note Index, Leveraged Loans represented by Morningstar LSTA US Leveraged Loan 100 Index. See index descriptions at the end of this presentation. 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.
With higher relative yields and a history of strong risk-adjusted returns, we believe CLOs should be a strategic allocation within an investor’s portfolio.
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 June 28, 2023.
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Index descriptions:
J.P. Morgan CLO Index is comprised of U.S. dollar denominated arbitrage CLOs of broadly syndicated loans.
AAA Rated CLOs represented by J.P. Morgan CLO AAA Index is a subset of the J.P. Morgan CLO Index that only tracks the AAA rated CLO.
AA Rated CLOs represented by J.P. Morgan CLO AA Index is a subset of the J.P. Morgan CLO Index that only tracks the AA rated CLO.
A Rated CLOs represented by J.P. Morgan CLO A Index is a subset of the J.P. Morgan CLO Index that only tracks the A rated CLO.
BBB Rated CLOs represented by J.P. Morgan CLO BBB Index is a subset of the J.P. Morgan CLO Index that only tracks the BB rated CLO.
BB Rated CLOs represented by J.P. Morgan CLO BB Index is a subset of the J.P. Morgan CLO Index that only tracks the BB rated CLO.
ICE BofA US Corporate Index (C0A0) tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market.
ICE BofA US High Yield Index (H0A0) tracks the performance of U.S. dollar-denominated below investment grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a below investment grade rating. Original issue zero coupon bonds, 144a securities, both with and without registration rights, and pay-in-kind securities, including toggle notes, qualify for inclusion. Eurodollar bonds, taxable and tax-exempt U.S. municipal, warrant-bearing, DRD-eligible and defaulted securities are excluded from the Index.
ICE BofA US Broad Market (US00) 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.
Morningstar LSTA US 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.
The S&P 500® Index consists of 500 widely held common stocks covering industrial, utility, financial and transportation sector; as an Index, it is unmanaged and is not a security in which investments can be made.
IMPORTANT DISCLOSURES
1 Source: S&P Global Ratings.
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 mentioned is 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 author(s), but not necessarily those of VanEck or its other employees.
An investment in the Fund 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.
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