Andrii Dodonov
An approach that looks beyond AAA CLOs may offer investors exposure to enhanced yield potential and relative value opportunities from a broader investment universe.
Collateralized loan obligations (CLOs), which are securitized pools of leveraged loans, may provide several attractive benefits within an income-oriented portfolio, including enhanced yields, structural risk protections and diversification. We believe CLOs are particularly attractive in today’s rising rate environment. They pay floating rate coupons that adjust upwards as rates increase and, unlike fixed coupon bonds, won’t suffer price declines as a result of higher rates.
The AAA tranche of a CLO typically comprises more than 60% of a CLO and therefore makes up the largest segment of the CLO market. However, we believe an approach beyond AAA CLOs can allow investors to benefit from enhanced yield potential and capture relative value opportunities from a broader investment universe, while maintaining a high quality, investment grade exposure.
As shown below, there is a wide dispersion of risk/return profiles among investment grade CLOs, with AAA rated bonds providing the lowest risk, but also the lowest return historically. Moving into AA and A rated CLOs may provide compelling opportunities. For example, AA rated CLOs have provided significantly higher returns than “core” U.S. bonds without significantly higher risk. They’ve also provided similar returns as leveraged loans with lower risk. This is notable because of both the floating rate nature of these asset classes, as well as the stark difference in credit quality (leveraged loans are typically rated BB and below and an investor in a loan fund has direct exposure to these borrowers). Single A CLOs have provided similar returns to high yield bonds with significantly lower volatility, and significantly higher returns than investment grade corporate bonds with similar volatility.
Attractive Risk-Adjusted Returns vs. Other Asset Classes
(10 Years as of 1/31/2023)
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 S&P/LSTA 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.
Constructing a CLO portfolio that spans this ratings spectrum allows an investor to benefit from the higher yields that exist within each rating category, while also benefiting from opportunities as they arise. For example, each ratings category tends to have a unique investor base and prices can therefore be impacted by different factors. A broad investment mandate can take advantage of any relative value opportunities that emerge across the ratings spectrum.
Dipping further into BBB CLOs (or even BB CLOs in certain periods) suggests much greater return potential, but also significantly greater volatility, emphasizing the need for risk management. The ability to construct a portfolio that can opportunistically add exposure in lower ratings categories when there is attractive value and de-risk ahead of periods of volatility provides another source of return potential.
In short, the ability to utilize the full CLO capital structure allows an active CLO tranche portfolio manager to find the most attractive value from the broad opportunity set, and construct an investment grade portfolio that provides enhanced yields relative to similarly rated bonds or loans. But CLO tranche investing is not simply about ratings buckets. Each CLO is unique, and a manager with deep leveraged finance experience will likely perform loan-level analysis to understand the fundamentals of the portfolio, while also performing cashflow analysis that takes deal specific terms into account along with stress tests within the loan portfolio. CLO market experience and presence is needed to understand whether a deal’s terms are more “debt friendly” or “equity friendly.”
Assessing the CLO manager is also critical. Each CLO is actively managed, and a manager’s style and capabilities can impact performance both overall and on a relative basis between the varying tranches of a particular CLO. This bottom-up security selection is then combined with top-down portfolio construction, which balances the tranche portfolio manager’s market outlook with liquidity and diversification considerations. The CLO tranche portfolio management team must also have the trading acumen and relationships to efficiently allocate and rebalance the portfolio. We believe a more passive or ratings-constrained approach means sacrificing the enhanced yield and return potential that a broader investment grade strategy may provide.
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.
Disclosures
CLO: J.P. Morgan Collateralized Loan Obligation Index (CLOIE) is the first rules-based total return benchmark for broadly-syndicated, arbitrage US CLO debt. Launched in July 2014, the index is in its seventh year of service. The index offers extensive coverage, tracking approximately 94% of the $660 bn total US CLO debt stock as of September 30th, 2021. Representing the entire debt capital structure, the index spans over 1,300+ deals and 7,000+ tranches managed by 130+ CLO managers.
AAA Rated CLOs represented by J.P. Morgan CLO AAA Index is a subset of the CLOIE index that only tracks the AAA rated CLO.
AA Rated CLOs represented by J.P. Morgan CLO AA Index is a subset of the CLOIE index that only tracks the AA rated CLO.
A Rated CLOs represented by J.P. Morgan CLO A Index is a subset of the CLOIE index that only tracks the A rated CLO.
BBB Rated CLOs represented by J.P. Morgan CLO BBB Index is a subset of the CLOIE index that only tracks the BB rated CLO.
BB Rated CLOs represented by J.P. Morgan CLO BB Index is a subset of the CLOIE index that only tracks the BB rated CLO.
US IG: ICE BofA US Corporate Index (C0A0) tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market.
AAA Rated Corps represented by the ICE BofA AAA US Corporate Index is a subset of the C0A0 index that only tracks the AAA rated corporate bonds.
AA Rated Corps represented by the ICE BofA AA US Corporate Index is a subset of the C0A0 index that only tracks the AAA rated corporate bonds.
A Rated Corps represented by the ICE BofA A US Corporate Index is a subset of the C0A0 index that only tracks the AAA rated corporate bonds.
BBB Rated Corps represented by the ICE BofA BBB US Corporate Index is a subset of the C0A0 index that only tracks the AAA rated corporate bonds.
US HY: ICE BofA US High Yield Index (H0A0) tracks the performance of U.S. dollar-denominated below investment grade corporate debt publically 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.
Agg: 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.
Leveraged Loans: S&P/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.
US IG FRN: MVIS US Investment Grade Floating Rate Index (MVFLTR) consists of U.S. dollar-denominated floating rate notes issued by corporate issuers and rated investment grade by at least one rating agency.
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.
© Van Eck Securities Corporation, Distributor, a wholly owned subsidiary of Van Eck Associates Corporation.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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