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The widely observed Bloomberg U.S. Aggregate Bond Index yields a decent 3.45%, but is down 9% over the past three years, underscoring the need for advisors to have other fixed income strategies ready for income-enthused clients.
There’s no shortage of alternatives to aggregate bond strategies and thanks to exchange traded funds, the field of unique fixed income offerings accessible to advisors and clients is broadening at a rapid pace. Collateralized Loan Obligations (CLOs) are part of that conversation. Arguably left for dead following the global financial crisis, CLOs are now a $1 trillion corner of the bond market and one that’s more accessible to ordinary investors thanks to ETFs.
In fact, there are myriad CLO ETF options for advisors to consider, many of which meet the $100 million in assets under management threshold needed to appear on various custody platforms. Good news, but that’s only part of the battle. CLOs are often viewed as a complex asset class meaning advisors should be ready to demystify it for clients while highlighting advantages pertaining to CLOs.
CLOs Have Perks
CLOs are attractive and unique because they feature above-average levels of income with sturdy credit quality – a combination that’s often difficult to find in the bond market. Additionally, this is an asset class that is conducive to considering actively managed funds or ETFs because CLOs themselves are actively managed – a potential selling point for skittish clients.
On that note, advisors should attain at least foundational knowledge of how CLOs are structured and function because today’s increasingly sophisticated clients may have questions regarding how CLOs’ deliver stout levels of income.
“Each CLO issues a series of floating rate bonds, along with a first-loss equity tranche. The tranches differ in terms of subordination and priority—and, thus, rank lowest to highest in order of riskiness (and return),” according to VanEck research. “The cash flows generated from the underlying portfolio of loans is used to pay interest sequentially to CLO debt holders, starting with the most senior AAA tranche.”
From there, remaining cash flows are paid to CLO tranches with AA and below ratings. Then, if there’s cash flow left over, it flows to the equity component in the CLO tranche.
“Due to credit enhancements, priority of cash flows, diversification, active management and other risk protections, most tranches earn investment grade ratings despite the underlying leveraged loans themselves having below investment grade ratings,” adds VanEck.
Two More Important CLO Tidbits
As noted above, CLOs took some lumps on the back of the global financial crisis, but that was a case of guilt by association than legitimate guilt. Said it another way, it was collateralized debt obligations (CDOs), NOT CLOs, that were the culprits when markets tumbled in 2008.
Speaking of tumultuous market environments, CLOs have a history of being fixed income refuges for clients and that was on display during the brief coronavirus bear market in 2020 and prior to that.
“CLOs experienced fewer defaults than corporate bonds of the same rating during and in the years following the global financial crisis (and also during the COVID-19 drawdown). No AAA or AA rated CLO has ever defaulted, and default rates even at the BBB level are extremely rare historically,” concludes VanEck.