CLOs: A Rising Rate Alternative

Collateralized loan obligations (CLOs) have historically offered many benefits that make them attractive relative to 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 relative to other corporate debt categories, including leveraged loans, high yield bonds, and investment grade bonds, and have significantly outperformed at lower rating tiers.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 with investment grade corporates, as well as other higher-yielding debt sectors—notably high yield and leveraged loans—CLO spreads are especially compelling.

Tested through two major crises. CLOs have 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—that have historically helped them experience lower levels of principal loss when compared with corporate debt and other securitized products. 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, of the approximately $500B of U.S. CLOs issued from 1994-2009 and rated by S&P, only 0.88% experienced defaults. 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.

CLOs Even More Attractive in the Current Market Environment

In addition to higher yields and stronger risk profiles, CLOs are floating rate instruments, which means their coupons reset each quarter along with prevailing interest rates, resulting in low price sensitivity to changes in interest rates. In a rising rate environment, such as the one we are in currently, CLO investors may actually benefit from higher coupons. As the table below highlights, this feature has helped CLOs historically outperform in periods of rising rates. This includes the most recent period of rising rates beginning in August of 2021 and ending in October of 2022.

CLOs Historically Outperformed in Rising Rate Environments

Source: VanEck, Morningstar and JP Morgan as of 12/31/2022. CLOs is 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 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.

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. Because CLOs are issued and managed by asset managers, the most critical decision a CLO investor can make is the selection of a manager, which isn’t an easy decision. Each CLO manager creates their own portfolios using their own investment style. And while historical performance varies greatly among managers, there are several key traits that successful managers share. Experience is the most important. There’s no substitute for deep CLO management experience, which provides the combination of credit expertise, access to new deals, trading acumen, risk management, and understanding of the unique needs of CLO tranche and equity investor needs 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 must perform rigorous due diligence on CLO managers to understand their capabilities and style, and tier them accordingly. However, the analysis does not end there. Each CLO is unique, even those managed by the same CLO manager. CLO tranche portfolio managers must understand the loan collateral and structural features that drive ultimate returns. This involves cashflow modelling and access to underlying CLO portfolio information, as well as real time pricing information to identify potential value.

Lastly, a CLO tranche portfolio manager must take into account overall exposures in terms of vintage, manager, and underlying sector exposure. It is also important to conduct ongoing monitoring to identify potential early warning signs in the CLO portfolios. A CLO tranche portfolio manager who can identify relative value across the CLO capital stack can add value by allocating to more attractively valued segments while avoiding those that are overpriced. Relative value analysis between primary and secondary market deals also plays a role, and a CLO investor must have both access and trading expertise to source attractive deals. 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 in periods of market stress.

In short, a passive approach is simply not feasible in the CLO space, and there is significant room to add value through an active approach that has flexibility to identify attractive value.

Learn more about the VanEck CLO ETF (CLOI).

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