CLOs Belong in Your Core: Q&A with Laila Kollmorgen

Source: PineBridge Investments. This is not an offer to buy or sell, or recommendation to buy or sell any of the securities mentioned herein.

How does the structure of a CLO help its risk profile?

One of the biggest misconceptions about CLOs is that they are inherently risky. In fact, the opposite is true. CLOs, structurally, have built-in risk protections that have historically helped them experience lower levels of principal loss when compared with corporate debt and other securitized products. This built-in risk protection comes in many forms, including active management, credit support, covenants and collateral requirements, and excess spread.

CLOs Benefit from Multiple Structural Protections

These structural protections have been tested through two major market crises. Many investors are surprised to learn that through both the Global Financial Crisis and COVID-19 drawdown, the asset class ultimately experienced fewer defaults than corporate bonds of the same rating—this resilience combined with the potential for upside returns makes the asset class compelling for long-term minded investors.

How do CLOs compare to other income investments?

Historically, CLOs have offered a higher yield relative to other corporate debt categories, including bank loans, high yield bonds, and investment grade bonds. Once investors start to understand the attractive risk profile of CLOs, I’m often asked how this is possible. If it is less risky and has historically experienced fewer defaults, why does a CLO tranche consistently have a higher spread compared to similarly rated corporate bonds?

The first thing I point out is that CLOs are complex, which adds a premium. In addition, due to regulatory changes following the 2008 Global Financial Crisis, large, regulated investors like banks and insurance companies had the minimum risk based capital requirements raised for CLOs, meaning that this investor base requires a higher spread to invest in the asset class. And this raises another common misconception about CLOs—many investors think they are illiquid. We’ve all read the articles about the illiquidity in the US Treasury and IG bond markets. However, the difference for CLOs is that the asset class doesn’t rely on 10 market makers to provide liquidity. CLOs, like all securitizations, trade in an auction process. Lists are sent out typically for next day trading. This allows time for investors like us to analyze the deals and determine if we want to participate in the auction. Investment grade tranches typically get a significant number of bids, and even high yield down to single B tranches will typically get multiple bids. In times of market stress, fewer bids may be received (as would be anticipated in even Treasury and IG markets), but the difference is that in the CLO market, many of the bids are coming from end accounts and not a dealer.

While CLOs are floating rate instruments, meaning they have low sensitivity to changes in interest rates, prices do change as a result of spread duration. As interest rates rise or fall, CLO yields and prices will move accordingly. However, because CLO spread duration is lower than a typical IG, CLO prices have historically moved less. These characteristics can be advantageous to investors in diversified fixed income portfolios.

The Attractive Risk-Adjusted Returns of CLOs vs Other Asset Classes (10 Years as of 3/31/2024)

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 Morningstar LSTA US 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.

Source: PineBridge Investments. For illustrative purposes only. Any views represent the opinion of the investment manager and are subject to change. Risk process and frequency subject to change at the discretion of management as warranted by market volatility or other considerations. Past performance is not indicative of future results.

How should investors think about CLOs in their broader fixed income portfolio?

We believe CLOs should be part of an investor’s core bond portfolio. As the chart below shows, adding anywhere from a 10-30% CLO allocation to a broad market allocation may increase the yield in a portfolio, increases the Sharpe ratio and decreases the potential max drawdown.

Adding CLOs Provided Better Outcomes (as of 3/31/2024)

And Better Yields (as of 3/31/2024)

Source: JP Morgan and ICE Data Services. CLOs refers to the J.P. Morgan Collateralized Loan Obligation Index (CLOIE) and Agg refers to the ICE BofA US Broad Market Index. 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 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. For illustrative purposes only.

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.

To receive more Income Investing insights, sign up in our subscription center.