CLOs: an alternative to rising rates
With higher relative yields, a track record of strong risk-adjusted returns and protection against rising rates, we believe now is the perfect time to strategically allocate to CLOs.
Secured Loan Obligations (CLO) have historically offered many advantages that make them attractive over other fixed income investments like leveraged loans, high yield bonds, and investment grade bonds:
Attractive performance. Over the long term, CLO tranches have performed well against other categories of corporate debt, including leveraged loans, high yield bonds and investment grade bonds, and have significantly outperformed lower rating levels.1
Wider yield spreads. CLO spreads have historically been significantly wider than those of other debt instruments, reflecting both the structured nature of CLO debt, the underlying loan portfolios as well as relatively lower liquidity and certain regulatory requirements. Compared to investment-grade companies, as well as other higher-yielding debt sectors, including high-yield and leveraged loans, CLO spreads are particularly attractive.
Tested through two major crises. CLOs have built-in risk protection– which stems from the strength of their underlying collateral as well as structural features, such as hedging tests to correct collateral deterioration – which have historically helped them sustain lower principal loss levels than the corporate debt and other securitized products. During the global financial crisis and the COVID-19 downturn, the asset class ultimately experienced far fewer defaults than corporate bonds of the same rating. For example, of the roughly $500 billion in US CLOs issued between 1994 and 2009 and rated by S&P, only 0.88% defaulted. And the performance is even better for Investment Grade CLOs. In the highest rated AAA and AA CLO tranches, there were no defaults. We believe this resilience, combined with the potential for upside returns, makes the asset class attractive to long-term investors.
Even more attractive CLOs in the current market environment
In addition to higher yields and stronger risk profiles, CLOs are floating rate instruments, meaning their coupons reset quarterly based on prevailing interest rates, resulting in low price sensitivity. to changes in interest rates. In a rising rate environment, such as the one we currently find ourselves in, CLO investors can actually benefit from higher coupons. As shown in the table below, this characteristic has allowed CLOs to historically outperform during periods of rising rates. This includes the most recent rate hike period which began in August 2021 and, with inflation still in its infancyhas no end in sight.
CLOs have historically outperformed in rising rate environments
Source: VanEck, Morningstar and JP Morgan as of 04/30/2022. CLOs are represented by the JPM CLOIE Index, US Treasury is the ICE BofA US Treasury Index, US IG is the ICE BofA US Corporate Index and US IG FRN is the MVIS US Investment Grade Floating Rate Index. Past performance does not represent future results. This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities mentioned herein.
Choosing the Right CLO Manager
While CLOs can be an effective hedge against rising interest rates, they remain complex instruments that require a high degree of expertise. Since CLOs are issued and managed by asset managers, the most critical decision a CLO investor can make is the selection of a manager, which is not an easy decision. Each CLO manager creates their own portfolios using their own investment style. And while historical performance varies greatly from manager to manager, there are several key traits that successful managers share. Experience is the most important. There is no substitute for in-depth experience in CLO management, which offers the combination of credit expertise, access to new transactions, trading acumen, risk management and an understanding of the unique needs of the CLO tranche and the needs of equity investors to generate strong returns. The benefit of having managed CLO portfolios before, during and after the financial crisis is incalculable.
An experienced CLO tranche portfolio manager should perform rigorous due diligence on CLO managers to understand their capabilities and style, and prioritize them accordingly. However, the analysis does not stop there. Each CLO is unique, even those managed by the same CLO manager. CLO tranche portfolio managers need to understand the loan guarantees and structural features that drive ultimate returns. This involves cash flow modeling and access to underlying CLO portfolio information, as well as real-time price information to identify potential value.
Finally, a CLO tranche portfolio manager must consider overall exposures in terms of vintage, manager and underlying sector exposure. It is also important to perform continuous monitoring to identify potential warning signs in CLO portfolios. A CLO tranche portfolio manager who can identify relative value in the CLO capital stack can add value by allocating to more attractive segments while avoiding overvalued ones. Analysis of the relative value between transactions in the primary and secondary markets also plays a role, and a CLO investor must have both access and trading expertise to find attractive transactions. From a risk management perspective, the CLO tranche portfolio manager must manage downgrade risk, as well as liquidity and have the ability to “de-risk” the portfolio during times of market stress.
In short, a passive approach is simply not feasible in the CLO space, and there is significant scope to add value through a active approach that has the flexibility to identify attractive value.
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Originally published by VanEck on June 23, 2022.
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1 9.5 year annualized returns as of 06/30/2021. Sources: JP Morgan, Bloomberg and S&P/LCD. US CLO debt represented by the JP Morgan CLOIE index; IG Credit: Bloomberg US Credit Index; High yield bonds: Bloomberg US Corporate High Yield Bond Index; Leveraged Loans: S&P/LSTA Leveraged Loan Index.
Please note that VanEck may offer investment products that invest in the asset class(es) or industries included herein.
JP Morgan Collateralized Loan Obligation Index (CLOIE) is the first rules-based total return benchmark for widely syndicated and arbitrage U.S. CLO debt. MVIS US Investment Grade Floating Rate Index (MVFLTR) consists of floating rate notes denominated in US dollars issued by private issuers and rated “investment grade” by at least one rating agency. ICE BofA US Treasury Index measures the performance of publicly issued US dollar-denominated US Treasury bills in the US domestic market. ICE BofA US Company Index tracks the performance of publicly issued US dollar-denominated investment grade debt securities in the US domestic market.
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 imply the provision 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, speak as of the date of this communication and are subject to change without notice. Information provided by third party sources is believed to be reliable and has not been independently verified as to its accuracy or completeness and cannot be guaranteed. The information contained herein represents the opinion of the author(s), but not necessarily that of VanEck.
An investment in a Collateralized Loan Obligation (CLO) may be subject to risks which include, but are not limited to, debt securities, replacement of LIBOR, foreign currencies, foreign securities, orientation of investments, securities newly issued, extended settlement, management, derivatives, cash, market, operational, commercial and non-diversified risk transactions. CLOs may also be subject to liquidity, interest rate, floating rate note, credit, call, extension, high yield securities, income, valuation, securities issued by the private sector, covenant lite loans, default of the underlying asset and CLO manager risk, all of which may adversely affect the value of the investment.
Any investment is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that the investment objectives will be achieved and investors may lose money. Diversification does not guarantee a profit or protect against loss in a declining market. Past performance is not indicative of future results.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.