This article was originally published on ETFTrends.com.
CLOs have historically offered a compelling combination of above-average yield, strong risk profiles, and the potential for strong upside appreciation.
Over the long term, collateralized loan obligation (CLO) tranches have historically 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. CLOs are structured to help mitigate risk, through the strength of their underlying collateral as well as built-in traits such as coverage tests to correct collateral deterioration. This has historically helped them experience significantly 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, particularly among investment grade rated CLO tranches.
CLOs Track Record of Strong Risk-Adjusted Returns vs. Other Asset Classes
10 Years as of 5/31/2022
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 BofAUS Broad Market; US IG FRNs represented by MVIS US Investment Grade Floating Rate Note Index; Leveraged Loans represented by S&P/LSTA Leveraged Loan 100 Index. 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.
CLOs Have Been Tested Through Two Major Crises
Through both the Global Financial Crisis and COVID-19 drawdown, the asset class ultimately experienced far fewer defaults than corporate bonds of the same rating. For example, among the nearly 17,000 U.S. CLOs issued from 1996-2020 and rated by S&P, only 0.4% experienced defaults, primarily in non-investment grade rated tranches. And the performance is even better for investment grade CLOs. In the higher rated AAA and AA CLO tranches, there have been zero defaults. We believe this resilience combined with the potential for upside returns makes the asset class compelling for long-term minded investors.
The Search for Income is Over
In addition to this strong track record of risk-adjusted returns, CLO spreads have historically been significantly wider than those of other debt instruments.
Consistent Spread Pickup by CLOs Compared to Similarly Rated Bonds*
(In bps as of 5/31/2022)
Source:* Using option-adjusted spread for corporate bonds and discount margins for CLOs. JP Morgan and ICE Data Services. 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, AAA Rated Corps represented by the ICE BofA AAA US Corporate Index, AA Rated Corps represented by the ICE BofA AA US Corporate Index, A Rated Corps represented by the ICE BofA A US Corporate Index and BBB Rated Corps represented by the ICE BofA BBB US Corporate Index. 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.
CLOs Have Lower Sensitivity to Interest Rates
CLOs are also floating-rate instruments, meaning they have low sensitivity to changes in interest rates. As interest rates rise or fall, CLO yields will move accordingly, and their prices have historically moved less than those of fixed-rate instruments. These characteristics may be advantageous to investors in diversified fixed income portfolios.
With higher relative yields, a history of strong risk-adjusted returns, and protection against rising rates, we believe there are several benefits to making a strategic allocation to investment grade CLOs within an income portfolio.
How to Invest in CLOs
The CLO market is largely institutional, with banks, insurance companies and hedge funds often purchasing CLOs directly or through institutional separate accounts that may carry minimums of $50M or more. This may make access difficult for many investors.
The VanEck CLO ETF (CLOI) may offer an attractive way for investors to efficiently access this market with the liquidity, transparency and low cost features of an ETF. CLOI invests primarily in investment grade CLO tranches and may invest up to 20% in BB-rated CLOs, but will not invest in CLOs rated below BB-/Ba3 or equity tranches of CLOs. The ETF is actively managed by PineBridge Investments, the fund’s sub-adviser.
CLOI aims to provide an enhanced yield by identifying the most attractive segments of the CLO market, while avoiding downgrades and default losses. PineBridge can move throughout the CLO capital structure to potentially add alpha, adding risk when there are opportunities and de-risking in periods of market volatility.
For more news, information, and strategy, visit the Beyond Basic Beta Channel.
Originally published by VanEck on July 15, 2022.
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 the VanEck CLO ETF (CLOI) may be subject to risks which include, among others, Collateralized Loan Obligations (CLO), debt securities, LIBOR Replacement, foreign currency, foreign securities, investment focus, newly-issued securities, extended settlement, affiliated fund, management, derivatives, cash transactions, market, Sub-Adviser, operational, authorized participant concentration, new fund, absence of prior active market, trading issues, fund shares trading, premium/discount, liquidity of fund shares, non-diversified, and seed investor risks. The Fund 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 Fund.
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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