CLOs: Too Good to Be True?

One of the most frequently asked questions we receive from investors new to collateralized loan obligations (CLOs) is whether their higher yield and spread profile with near-zero default risk is “too good to be true.” How is this risk/return profile, which has driven the most attractive risk-adjusted returns in fixed income over the past decade, possible? There are several factors that help explain this:

1. High yielding collateral: CLOs are backed by a pool of leveraged loans, which are non-investment grade and produce high levels of income that gets distributed to CLO tranche investors. As of February 29, 2024, leveraged loans yielded 9.2% versus 5.5% on investment grade (IG) corporate bonds.
2. Structural protections: Each tranche of a CLO has varying degrees of subordination, which insulates investors from default losses. Active management, collateral requirements, and overcollateralization provide additional protection. Combined with the lower loss rates on senior secured loans relative to high yield bonds, the risk of default in investment grade CLO tranches is negligible. The average CLO portfolio would need to experience default rates several multiples of the historical average, typically for several consecutive years, for the first dollar of loss even in BBB and BB rated tranches. There has never been a default in AAA rated CLOs.

Extreme Levels of Defaults Would Be Needed to Impair A CLO Tranche

Source: PineBridge Investments analysis as of 2/28/2024 and J.P. Morgan for Leveraged Loan Annual Default Rate (2001-2023). Any views represent the opinion of the investment manager, are valid as of the date indicated and are subject to change. 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.

3. CLO market structure: CLOs are not homogenous (even those with the same rating are not one in the same) and require extensive due diligence before investing, introducing a risk premium. Every portfolio is different in terms of underlying issuers, sectors and vintages. Deal documentation can vary, as well as CLO manager style. These differences highlight the need for active management by an experienced CLO tranche portfolio management team. Further, each tranche has a unique investor base with different return targets, which can drive yields higher. For example, banks are the biggest investors in AAA CLOs, and a CLO cannot be issued without placing the AAA tranche. Accordingly, changes to bank capital requirements can have an outsized impact on AAA CLO spread levels. Lastly, non-institutional investors have not had access to the asset class until recently with the advent of CLO ETFs.

After walking through these points, the follow-up question is often “if that’s true, what can go wrong?” Although default risk is not the primary risk of CLO tranche investing, CLO tranche investing is not risk-free. In particular, spread and downgrade risk need to be carefully monitored. Deterioration in the underlying loan market can result in downgrades of CLO tranches, which can drive prices lower. And like any credit investment, wider spreads will impact market values. March 2020 provides a recent example of how CLOs perform versus other corporate asset classes in a tail-risk scenario (see exhibit).

CLOs Fared Much Better than High Yield and Leveraged Loans During the Covid-Fueled Sell-Off in March 2020

Source: ICE Data Indices, Morningstar. Drawdown is the largest drop from a peak to a bottom from March 1, 2020 to March 30, 2020. CLOs represented by J.P. Morgan CLO Index; HY Corporates represented by ICE BofA High Yield Index; US Treasuries represented by ICE BofA US Treasury Index; IG Corporates represented by ICE BofA US Corporate Bond Index; Leveraged Loans represented by Morningstar LSTA US Leveraged Loan 100 Index. Index performance is not representative of Fund performance. It is not possible to invest directly in an index.

CLOs, in aggregate (i.e. from AAA to BB rated tranches) experienced a drawdown similar to investment grade corporate bonds during the COVID selloff. High yield bonds and leveraged loans fared much worse. In addition, CLOs fully recovered by August 2020 and did not experience a spike in defaults. So, CLOs are clearly not free from market risk, but an allocation did not add more downside risk versus other credit sectors in this extreme volatility, even with exposure to CLOs rated below AAA.

Conclusion

CLOs have had a compelling run over the past decade, especially when compared to their fixed income peers. Like all investments – CLOs are not risk free, and tail risks, like the March 2020 Covid sell-off, do occur. But, even in that scenario, CLOs performed in line with investment grade corporate bonds, and better than high yield bonds and leveraged loans. We believe this resilience illustrates that, rather than being “too good to be true,” the structural features of CLOs and the CLO market explain why this asset class has been able to perform so well.

The VanEck CLO ETF (CLOI) and VanEck AA-BB CLO ETF (CLOB) are actively managed ETFs, sub-advised by PineBridge Investments. CLOI provides access to investment grade CLOs, and CLOB invests primarily in mezzanine tranches of CLOs. Both ETFs benefit from PineBridge’s decades of CLO market experience, both as a CLO manager and CLO tranche investor, and deep leveraged finance expertise.

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