CLOs Offer High Yield & Low Risk

If there is one thing investment banks are really good at, it’s securitization. That is taking an asset and packaging it for investment. CLOs are essentially a “package” of loans – typically 150 to 250 loans – that are placed into a single security. In this case, the debt is senior secured loans made to corporate or private equity borrowers. But other debt, including fixed rate securities, can be part of the package, depending on the mandate of the collateralized loan obligation. All in all, CLOs are a way for banks/lenders to remove their loans from their balances and into investors’ hands.

The key for CLOs is that they are actively managed.

A CLO manager raises funds from investors and then buys pools of debt. The key for CLOs is that managers will divide the pool into what is known as “tranches.” Each tranche comes with a different set of credit risk, rated AAA down to BB, with an equity tranche at the very bottom. This distinction allows for investors to hone their risk profile to suit their needs. This is also important as the various tranches represent their placement in the capital stack and how cash flow and losses are dealt with.

So, investors at the very top are paid first and then cash flow from the loans trickles down to the lower levels. At the same time, when losses do occur, those at the bottom of the CLO stack feel the pain first. However, investors are potentially compensated for the additional risk of being at the bottom with higher yields.

As the various underlying loans are paid off, the CLO manager will distribute those funds in order of seniority of the tranches, with any remaining proceeds returning to the equity holders at the bottom.

Be sure to explore the Bank Loans page to check all funds.

Given the complexity of the product, why would investors even want to bother with the security type in the first place? For one thing, yields. Yields on CLOs have offered very attractive payouts when compared to other “risky” varieties of corporate debt. This includes junk bonds and individual senior loans.

Secondly, that yield offers plenty of inflation fighting. Most CLOs own senior debt that is floating rate and tied to Secured Overnight Financing Rate or previously LIBOR. Because of this, interest payments on these loans will “float” with changes to interest rates, offering plenty of inflation protection.

Finally, there’s safety to be had in a CLO. As senior loans, in the event of bankruptcy these loans are prioritized to be repaid first and are often tied to a piece of equipment or asset. This has historically led to lower default rates and higher recoveries for senior loans when compared to unsecured high-yield bonds like junk.

Another point about safety, nearly 80% of CLOs issued carry a credit rating from A to AAA. That strong investment grade rating has been amazing when it comes to default rates. According to S&P Global, of the $500 billion worth of all U.S. CLOs issued from 1994 to 2009, only 0.88% have experienced defaults. For those higher rated categories – AAA and AA – there have been zero defaults.

This also brings up an interesting point. CLOs are not collateralized debt obligations (CDOs). If you remember, CDOs played a massive role in the credit crisis and during the Great Recession. These securities were pools of subprime mortgages, credit card receivables, high interest auto loans and other risky debt that were securitized and sold to investors.

These toxic assets were unsecured pools of loans and featured overall poor credit quality. As such, default rates were very high and investors received next to nothing for their losses.

This is in stark contrast to CLOs and their pools of investment grade loans tied to assets as well as placement in the bankruptcy stack.

Given the uniqueness of the asset class, fixed income investors may want to take a look at CLOs for their fixed income portfolios. Historically, the asset class has been able to be tapped by high-net-worth investors, pension funds and other institutional investors. However, these days, accessing CLOs has gotten easier.

Both the VanEck CLO ETF (CLOI) and Janus Henderson AAA CLO ETF (JAAA) offer ETF exposure to the asset class. The funds are relatively new and small, but they could see support as more investors turn towards it. Both offer yields of nearly 6%.

There are also several closed-end funds that participate in the asset class. For example, Ares Dynamic Credit Allocation Fund (ARDC), OFS Credit Company (OCCI) and Oxford Lane Capital (OXLC) offer exposure to the sector.

All in all, CLOs offer a unique asset class that was once reserved for institutional investors. With CLOs, investors can get safety and high yields. And thanks to new one ticker access, retail investors can add a swath to their portfolios.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.