Looking Beyond AAA Rated CLOs Pays Off
March 22, 2024
Read Time 3 MIN
Investors new to collateralized loan obligations (CLOs) wary of whether the asset class is “too good to be true” may choose to constrain themselves to AAAs, but we believe this is misguided. Although downgrade risk and spread volatility increase as you move down in quality, and liquidity can decrease, the yield and return potential offered in lower rated tranches is far greater.
Consider that:
- The aggregate CLO market, which represents the entire capital structure and is approximately 67% AAA CLOs, outperformed the AAA only subset by +117 basis points (bps) per year over the past five years.
- Single A CLOs outperformed AAA CLOs by 130 bps per year over the past decade, with volatility that was lower than IG corporate bonds.
- BBB CLOs provide a yield pickup over AAA CLOs of +219 bps, and provide a yield pickup over high yield bonds, with higher credit quality.
- AA rated CLOs provided a yield pickup over investment grade corporates of 120 bps, and 171 bps over an aggregate exposure, underscoring the case for an allocation to CLOs within a core bond portfolio.
CLOI | VanEck CLO ETF
Lower Rated CLO Tranches Have Higher Yields
Source: ICE Data Indices, J.P. Morgan. CLOs represented by J.P. Morgan CLO Index or the ratings subset of the J.P. Morgan CLO Index; HY Corporates represented by ICE BofA High Yield Index; US IG represented by ICE BofA US Corporate Bond Index; US Agg represented by ICE BofA US Broad Market Index. Index performance is not illustrative of fund performance. It is not possible to invest directly in an index.
We also note that the CLO yields in the chart already assume a decline in short-term rates, as market convention in the asset class is to use the forward interest rate curve. Further, CLO yields assume a certain loss rate in the calculation, so default assumptions are already reflected. This may provide additional comfort to those who are wary of investing outside of AAA tranches. Corporate bond yields do not make similar adjustments for potential defaults.
The ability to move into higher yielding lower rated tranches, which have yields that are driven more by credit spreads versus short-term risk-free rates, may allow investors to continue earning high absolute levels of income even in an environment of declining interest rates. For example, in a risk off environment, even if the Fed cut rates aggressively it is likely that overall yields could increase due to spread widening, particularly in single A, BBB, and BB rated tranches, dispelling the notion that CLOs are only attractive in rising rate environments. In a more benign environment such as we are in currently, moving further down the CLO capital stack can provide the opportunity for higher carry compared to AAA CLOs, while remaining well insulated from underlying loan defaults and volatility.
Further, the ability to move within the full CLO capital structure can provide attractive total return opportunities as the rate and credit environment shift. For example, highly rated CLOs may provide insulation against a risk-off environment, but the ability to capture higher value in mezzanine tranches after a sell-off can allow significant upside potential as prices recover.
Navigating the CLO capital stack is where the value of active tranche management shines. An active approach provides both alpha potential and additional risk protections: through bottom-up analysis of underlying exposures, identifying/avoiding mispriced deals (and in some cases, avoiding lower rated tranches altogether) and active liquidity management. The ability to understand the various drivers of CLO risk is key in assessing the relative value of a tranche. PineBridge has decades of expertise in the CLO market and takes an active, high conviction approach to investing in CLO tranches. The VanEck CLO ETF (CLOI) is actively managed and based on a strategy that PineBridge has managed for years for its institutional clients, and is now available to all investors with the transparency, liquidity and cost benefits of an ETF.
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Disclosures
ICE BofA US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market.
ICE BofA US High Yield Index tracks the performance of U.S. dollar-denominated below investment grade corporate debt publically issued in the U.S. domestic market.
ICE BofA US Broad Market tracks the performance of US dollar denominated investment grade debt publicly issued in the US domestic market, including US Treasury, quasi-government, corporate, securitized and collateralized securities.
ICE BofA US Treasury Index tracks the performance of US dollar denominated sovereign debt publicly issued by the US government in its domestic market.
J.P. Morgan Collateralized Loan Obligation Index tracks US dollar denominated broadly-syndicated, arbitrage CLOs.
Morningstar LSTA US Leveraged Loan 100 Index seeks to mirror the market-weighted performance of the largest institutional leveraged loans as determined by criteria based upon market weightings, spreads, and interest payments.
This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities, financial instruments or digital assets mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, tax advice, or any call to action. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results, are for illustrative purposes only, are valid as of the date of this communication, and are subject to change without notice. Actual future performance of any assets or industries mentioned are unknown. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. VanEck does not guarantee the accuracy of third party data. The information herein represents the opinion of the speaker(s), but not necessarily those of VanEck or its other employees.
The Fund’s benchmark is the JP Morgan CLOIE Index which is the first rules-based total return benchmark for broadly-syndicated, arbitrage US CLO debt. Information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The Index is used with permission. The index may not be copied, used or distributed without J.P. Morgan’s written approval. © 2024, J.P. Morgan Chase & Co. All rights reserved. Index performance is not representative of Fund performance. It is not possible to invest directly in an index.
An investment in the VanEck CLO ETF (CLOI) may be subject to risks which include, but are not limited to, risks related to Collateralized Loan Obligations (CLO), debt securities, LIBOR Replacement, foreign currency, foreign securities, investment focus, newly-issued securities, extended settlement, affiliated fund investment, management and capital preservation, derivatives, cash transactions, market, Sub-Adviser, operational, authorized participant concentration, no guarantee of active trading market, trading issues, fund shares trading, premium/discount, liquidity of fund shares, non-diversified, and seed investor risks, all of which may adversely affect the Fund. Investments in debt securities may expose the Fund to other risks, such as risks related to liquidity, interest rate, floating rate obligations, credit, call, extension, high yield securities, income, valuation, privately-issued securities, covenant lite loans, default of the underlying asset and CLO manager risks, all of which may impact the Fund’s performance. Derivatives may involve certain costs and risks such as liquidity, interest rate, and the risk that a position could not be closed when most advantageous.
Investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider the investment objective, risks, charges and expenses of the Funds carefully before investing. To obtain a prospectus and summary prospectus, which contain this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus carefully before investing.
© Van Eck Securities Corporation, Distributor, a wholly owned subsidiary of Van Eck Associates Corporation.
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Disclosures
ICE BofA US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market.
ICE BofA US High Yield Index tracks the performance of U.S. dollar-denominated below investment grade corporate debt publically issued in the U.S. domestic market.
ICE BofA US Broad Market tracks the performance of US dollar denominated investment grade debt publicly issued in the US domestic market, including US Treasury, quasi-government, corporate, securitized and collateralized securities.
ICE BofA US Treasury Index tracks the performance of US dollar denominated sovereign debt publicly issued by the US government in its domestic market.
J.P. Morgan Collateralized Loan Obligation Index tracks US dollar denominated broadly-syndicated, arbitrage CLOs.
Morningstar LSTA US Leveraged Loan 100 Index seeks to mirror the market-weighted performance of the largest institutional leveraged loans as determined by criteria based upon market weightings, spreads, and interest payments.
This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities, financial instruments or digital assets mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, tax advice, or any call to action. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results, are for illustrative purposes only, are valid as of the date of this communication, and are subject to change without notice. Actual future performance of any assets or industries mentioned are unknown. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. VanEck does not guarantee the accuracy of third party data. The information herein represents the opinion of the speaker(s), but not necessarily those of VanEck or its other employees.
The Fund’s benchmark is the JP Morgan CLOIE Index which is the first rules-based total return benchmark for broadly-syndicated, arbitrage US CLO debt. Information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The Index is used with permission. The index may not be copied, used or distributed without J.P. Morgan’s written approval. © 2024, J.P. Morgan Chase & Co. All rights reserved. Index performance is not representative of Fund performance. It is not possible to invest directly in an index.
An investment in the VanEck CLO ETF (CLOI) may be subject to risks which include, but are not limited to, risks related to Collateralized Loan Obligations (CLO), debt securities, LIBOR Replacement, foreign currency, foreign securities, investment focus, newly-issued securities, extended settlement, affiliated fund investment, management and capital preservation, derivatives, cash transactions, market, Sub-Adviser, operational, authorized participant concentration, no guarantee of active trading market, trading issues, fund shares trading, premium/discount, liquidity of fund shares, non-diversified, and seed investor risks, all of which may adversely affect the Fund. Investments in debt securities may expose the Fund to other risks, such as risks related to liquidity, interest rate, floating rate obligations, credit, call, extension, high yield securities, income, valuation, privately-issued securities, covenant lite loans, default of the underlying asset and CLO manager risks, all of which may impact the Fund’s performance. Derivatives may involve certain costs and risks such as liquidity, interest rate, and the risk that a position could not be closed when most advantageous.
Investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider the investment objective, risks, charges and expenses of the Funds carefully before investing. To obtain a prospectus and summary prospectus, which contain this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus carefully before investing.
© Van Eck Securities Corporation, Distributor, a wholly owned subsidiary of Van Eck Associates Corporation.