CLOs Now a Core Necessity

Bond investors typically look to their core bond portfolios to provide a ballast against market volatility. However, core fixed income asset classes continue to feel the impact of “higher for longer” this year, as market expectations for rate cuts have adjusted to what the Fed has been telling us all along. Robust economic data over the past few weeks, and some upside inflation surprises, continue to support that outlook. By early April, the yield on the 10-year U.S. Treasury had risen by almost 50 basis points since their recent lows at the end of December. We don’t know if long-term bond yields will continue rising or decline from here, but we do expect rate volatility to remain elevated relative to the decade prior to this most recent rate hiking cycle.

This recent volatility is yet another reminder that core bond returns, even U.S. Treasuries, are heavily impacted by interest rate duration. Collateralized loan obligations (“CLOs”) are generally not included in “agg”-type indices that most core bond managers benchmark to, and therefore allocations tend to be relatively small or non-existent. However, CLOs provide the attributes that investors look for in their core bond portfolios: attractive yield, safety, and diversification, and have continued to outperform core fixed income through this most recent volatility. As a result, an allocation to CLOs in a core bond portfolio has provided better outcomes year to date.

CLOs Have Continue to Outperform in 2024

Source: J.P. Morgan and ICE Data Indices as of March 31, 2024. CLOs represented by J.P. Morgan CLO Index; AAA CLOs represented by the AAA subset of the J.P. Morgan CLO Index; Core Bonds represented by the ICE BofA US Broad Market Index.

In fact, CLOs have provided the best risk-adjusted returns versus other fixed income asset classes over the past decade, through various rate and credit cycles. CLO returns benefit from high yields and spreads versus similarly rated bonds, structural protections that have resulted in extremely low default risk, and rate insensitivity. More recently, strong technical and fundamentals have provided a tailwind to credit spreads. CLOs have outperformed core bonds as well as the broad high yield bond market this year.

For investors looking to add CLO exposure, we believe a broad investment grade exposure provides better opportunities versus one that is constrained to AAA CLOs. Today’s currently benign credit environment favors capturing higher carry outside of AAAs, while remaining cautious due to tighter valuations in CLOs rated BBB and below. The ability to take advantage of higher yields in lower-rated tranches also provides the opportunity to earn attractive absolute yield levels even in a declining environment. Looking forward, any weakening in the credit environment could create attractive total return opportunities for CLO tranche managers that can opportunistically add risk when value is pushed further into lower-rated tranches. Constraining a CLO investment strategy to only one rating category significantly reduces these opportunities.

An actively managed approach, in both top-down portfolio construction as well as rigorous bottom-up security selection, can add significant value in CLO investing. Right now such an approach, we believe, falls into a sweet spot of high carry with relative safety and stability – the attributes most investors look for in their core bond portfolio.

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.

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