Pursue Higher Yield Potential with CLOs

The benefits of investing in collateralized loan obligations (CLOs) have become increasingly clear to investors over the past several years. At each rating category, CLOs provide a higher yield than similarly rated bonds and loans. Even a few rate cuts will likely not diminish this advantage, particularly as one moves down the ratings spectrum, and historically the spreads offered on CLOs have been consistently and significantly higher. In addition to their higher yields and spreads, the way CLOs are structured has resulted in significantly lower default rates versus bonds and loans. We believe this combination of yield potential and higher quality makes CLOs attractive in a fixed income portfolio, along with the diversification benefits they provide.

CLOs Offer Higher Yield Than Similarly Rated Bonds and Loans

(as of 8/31/2024)

Source: JP Morgan and ICE Data Services as of 8/31/2024. US CLO is based on the JP Morgan CLO Index, Corp/HY is based on ICE BofA US Corporate Index and ICE BofA US High Yield Index, and Leveraged Loans refers to J.P. Morgan Leveraged Loan Index. Leveraged Loan yield represents yield modelled to a 3-year maturity. US CLO Yield to Worst represents yield to call for premium priced securities or to maturity when priced at a discount to par based on forward reference rates. See index descriptions at the end of this blog. 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. Index performance is not illustrative of fund performance. It is not possible to invest directly in an index.

The VanEck CLO ETF (CLOI), launched in June 2022, focuses on investment grade CLOs and offers investors a compelling way to add CLO exposure to their core bond portfolio. For investors seeking greater yield potential and who are able to tolerate additional volatility, the VanEck AA-BB CLO ETF (CLOB) provides a way to access lower rated, or “mezzanine,” tranches between the AAA and equity tranches. This part of the CLO capital structure offers significantly higher spreads, driving greater yield and total return potential. The increase in yield is particularly acute moving from A to BBB rated CLOs. For example, as shown in the chart below, BBB and BB rated CLOs have returned 5.9% and 9.3%, respectively, annually over the past decade. This compares to 3.5% for broad investment grade CLOs and 4.2% for U.S. high yield corporate bonds. However, this significantly greater return potential comes with heightened volatility, and other parts of the mezzanine universe, particularly AA and A rated CLOs, can provide a cushion against this volatility as well as greater liquidity. CLOB invests in the best opportunities within mezzanine CLOs, aiming to provide significantly greater return potential versus an AAA or investment grade strategy, with a strong focus on managing downside risk.

CLOs’ Risk-Adjusted Returns Attractive Relative to Other Asset Classes

(10 Years as of 8/31/2024)

Source: Morningstar. Broad CLOs represented by J.P. Morgan CLO Index, IG CLOs represented by J.P Morgan CLO IG Index, AA-BB CLOs represented by the J.P. Morgan CLOIE Balanced Mezzanine 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 blog. 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. Index performance is not illustrative of fund performance. It is not possible to invest directly in an index.

With attractive yields and built-in risk protections, mezzanine CLOs may be an attractive complement to a high yield bond portfolio. In addition, CLOB can provide diversification potential because of the floating rate nature of CLOs and the differences in underlying exposures. CLOs are backed by leveraged loans, which have different issuer and sector representation versus the high yield market. Alternatively, leveraged loan investors may find CLOB to be an attractive replacement for direct loan investments due to the structural protections that CLOs provide, without a significant impact on yield. On average, PineBridge Investments estimates¹ that even in a stressed market environment, it would take an annual default rate of nearly 10% within underlying loan portfolios to experience a default in BBB CLOs. That is more than three times higher than the historical average default rate of leverage loans. BB CLOs, on average, could incur a 6% annual default rate in the underlying loan portfolios, or about twice the historical average. CLOB also provides an efficient way to add tactical exposure to lower rated credit after significant market moves, allowing investors to capture a potential recovery in prices.

Similar to CLOI, CLOB is sub-advised by PineBridge Investments, bringing decades of CLO market expertise to investors through an ETF. PineBridge manages $2.5 billion in CLO tranche investments for institutional investors (as of 6/30/2024), and has been a CLO issuer since the 1990s. In addition to extensive due diligence on CLO managers, PineBridge looks through CLO portfolios to analyze each individual loan and make buy and sell decisions based on their fundamental views of the portfolio. They can then determine which tranche of a CLO provides the most attractive value. Combined with a top-down approach based on macro views, we believe this active approach can provide the best opportunities in CLO investing.

Downgrade risk increases as one moves further down the CLO capital stack and must be monitored closely. Within mezzanine CLOs in particular, PineBridge’s ability to perform loan-level analysis will be increasingly important given the growing dispersion beginning to appear in the credit market. In addition, following the first rate cuts by the Federal Reserve since 2020, a turn in U.S. monetary policy may generate added volatility in credit markets. With valuations currently very tight, unexpected events can drive sharp drawdowns and also provide opportunities.

CLOB’s active approach adapts to this changing environment and allows investors to capture opportunities when they arise. For example, an allocation to AA and A rated CLOs can provide a cushion against volatility as well as dry powder to take advantage of market selloffs and shift into lower rated tranches when value appears. In contrast, a strategy focused only on CLOs rated BBB and below may experience very steep drawdowns and will not be able to raise liquidity without realizing significant losses. We believe that a broader investment focus that can de-risk in periods of stress and opportunistically invest where there is the greatest value is the most prudent way for investors to approach mezzanine CLO investing.

The VanEck AA-BB CLO ETF (CLOB) is an actively managed ETF, sub-advised by PineBridge Investments, and invests primarily in mezzanine tranches of CLOs.

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