Unlocking CLO Opportunities with Fran Rodilosso and Bill Sokol

  

Today we have VanEck's Collateralized Loan Obligations team, Fran Rodilosso, the head of Fixed Income ETF Portfolio Management, and Bill Sokol, the Director of Product Management, with us to discuss their views on CLOs, why active management is key, and how advisors can approach due diligence and allocation to CLOs into an overall portfolio for clients.

Welcome to the podcast guys.

[00:00:34] Bill Sokol: Thanks for having us.

[00:00:35] Fran Rodilosso: Thank you very much. Looking forward to this

[00:00:38] Doug Heikkinen: Bill. Let's start with you. CLOs are often misunderstood and overlooked by many investors. Can you start by giving us a quick overview of what they are and why they present an attractive investment opportunity today?

[00:00:53] Bill Sokol: Yeah, of course. I think to your point, you know about being misunderstood and overlooked. I think the reason for that is that most investors just haven't had. access to CLOs until very recently with the advent of CLO ETFs. and now that these ETFs are available, we, are getting a lot of questions around what are CLOs and, how they can be used in a portfolio.

And the reason there's so much interest is that they do provide a very compelling combination of higher yields and higher quality versus other fixed income asset classes. there's zero rate sensitivity, and as we know in recent years that has been very beneficial. When we saw rising rates in 2022, 2023, and more recently, we've just seen a lot of rate volatility and we expect that to, to continue.

So that diversification you get, because these are floating rate, can provide a lot of value in a portfolio. because they're floating rate, CLOs are really a pure credit instrument. and they're very high quality, with very low default rates historically, lower than similarly rated bonds.

Actually, almost no defaults if you look at investment grade CLOs over the history of the asset class. So, I think these themes, higher yield, higher quality, and diversification. These are things that are, probably gonna recur in our discussion today. And I'm sure we're gonna dive a little more into each of those.

[00:02:27] Doug Heikkinen: Yeah. But before we do that, can you walk me through how CLOs are structured and the key benefits that they offer?

[00:02:34] Bill Sokol: Sure. So, a CLO is a securitized pool of leveraged loans. leveraged loans are sometimes referred to as bank loans or syndicated loans. These are senior and secured loans to cashflow generating companies, and they're secured by assets of the company. Because they're senior to other forms of debt that those issuers might have,

and because. they're secured by assets, they actually have a lower loss rate historically than high yield bonds. Typically, A CLO will hold 150 to 300 or even more individual loans. So, it's a highly diversified portfolio of leveraged loans. And the way the structure works is that the CLO will borrow from investors to purchase those underlying loans.

So, each of those investors in the CLO debt will earn interest that's paid. From what's generated by the underlying portfolio of leveraged loans, but those cash flows are not distributed on a pro rata basis to all of these investors. Instead, they're paid sequentially. So, you have a more se the most senior tranche and then other tranches that, are more junior and cash flows that are generated from the loan portfolio, interest and principal, are distributed through a, what's called a waterfall. So, the AAA is the most senior and that's gonna be paid first, and it's also the more, most insulated for many losses that occur in the portfolio.

and then you have AA single A down to typically double B, the double B tranche will have less subordination. It's gonna receive its interest after the more senior tranches. And then at the most junior, you have what's called the equity tranche. And the equity tranche is going to absorb, the any defaults first before any of the debt tranches.

And it's gonna receive all of the excess cash flows that's generated by the loan portfolio, after payment of interest to these debt holders. And that's gonna be a substantial amount because the equity tranche is taking a lot of risk. The ratings reflect, of course, the risk that you're taking and also the spreads or the interest that you're getting, as a tranche investor will reflect a level of risk.

So, the AAA tranche is gonna have the lowest spread, and that's gonna increase as you move into more junior tranches. This, the, structure of a CLO allows investors to tailor the level of risk that they want to take. And I think that's, important because remember, leverage loans are generally a non-investment grade asset class.

In fact, the average rating in the leverage loan universe is single B, but you can take AAA or investment grade exposure to this, asset class through a CLO. So, for example, you can get single A exposure through a CLO, that matches what you would get in your typical corporate bond. Passive exposure with the same average rating, but you get a yield pickup, you get a 70 basis point pickup at the same credit rating.

I would also note there's this other structural risk protections in addition to the way these are structured. So these are actively managed. You have a portfolio manager who is building the portfolio, the CLO portfolio. they're managing the portfolio to satisfy various covenants and collateral tests.

Things like interest coverage ratios and over collateralization ratios need to be satisfied. And if they're not, cash flows get diverted from the junior tranches to the more senior tranches. And all of this really just is meant to ensure that the more senior investors get paid first. and then lastly, you have the excess cash flows that the equity investors will earn.

but that's used as cushion to make up, any shortfalls that may exist in order to pay the debt holders.

[00:06:37] Doug Heikkinen: You mentioned corporate bonds. How do CLOs compare to other fixed income options like corporate bonds or syndicated loans?

[00:06:46] Bill Sokol: So these are all part of the leveraged finance market. When you say corporate bonds, I'm referring to high yield corporate bonds, lever syndicated loans or leveraged loans, and then CLOs, right?

This is what's called the leverage finance market. Borrowing made by non-investment grade companies. The biggest difference, I would say first that CLOs are securitized, right? They're structured investments. The CLO holds assets in this case, it actually holds the syndicated loans, and pays the, loan, the interest and the principal generated by the portfolio, sequentially, as I described earlier.

With bonds and loans, if you invest in a bond portfolio or a leveraged loan, mutual fund or ETF, you're, you have exposure to that entire portfolio. You don't have the benefit of the securitization, the subordination, that you would get with a CLO. for example, if you were to invest in a leverage loan strategy, you're exposed to any defaults that would occur in the portfolio because you don't have that subordination, you are getting more of, probably more a single B.

credit risk given the makeup of the leverage loan market. So that's very different of course, than what you can get with a CLO, but you are gonna get a higher spread because you are taking a lot more risk. And that will translate generally into higher, a higher, yield at least, versus an investment grade CLO. similarly with high yield bonds, high yield bonds, You're investing in the entire portfolio, you may be exposed to default losses and of course with high yield bonds, you're also getting, duration exposure because those are fixed rate versus the floating rate nature of CLOs and, leveraged loans. I would note, there's gonna be overlap between the borrowers in the high yield market and the leverage loan market. But there are different issuer sector exposure. So, you do get diversification, if you have say, a high yield, exposure already. Combining that with CLOs can provide diversification and other benefits. Lastly, I would just note that CLOs, so CLOs are securitized leveraged loans. So ultimately the risk and return is going to be driven by leveraged loans and it's not, what happens in the leveraged loan market will impact the CLO market.

leverage loans, as I mentioned, they are senior and secured. they've had lower loss rates than high yield bonds. And because of the structure of CLOs and the nature of the asset class, they've, performed very well historically in terms of default. If you looked at, even through the GFC, for example, CLOs perform very well.

And again, it's because of the underlying and the robustness of the structure.

[00:09:48] Doug Heikkinen: How large is the CLO marketplace and how liquid is it?

[00:09:54] Bill Sokol: So currently the global CLO market's about $1.2 trillion. That actually puts it at about the same size as the US high yield bond market. In terms of liquidity, I think it's important to note that CLO tranches are bonds, and they trade and settle like bonds. That's not the case with leveraged loans. but CLOs, do trade like bonds. The difference I think is that the CLO market has historically and then continues to be really dominated by large institutions and from, in terms of the investor base. So, banks and insurance companies are the biggest of CLOs.

You have to be what's known as a QIB to buy CLOs directly. and the way those CLOs trade is a little bit different than bonds. They typically are done through auctions between investors. but there is a very active secondary market. and actually, two years ago, two, three years ago, I guess at this point, we did see, a very good test of that, I think, or a good example of that, when the, in the UK LDI crisis, this is when, UK government bond prices declined very sharply, because of a, budget announcement that was made at the, then by the, then current government and a lot of pension funds in the UK had to, they were force sellers of, They had to raise liquidity because they had leverage exposure to UK government funds. But they didn't meet these margin calls that they had to satisfy by just selling government funds. They actually sold CLOs and this was well publicized at the time. They were selling billions of dollars of high rated, single A double A AAA CLOs and there were credit managers who were providing that liquidity at the time.

So there was a very active secondary market for CLOs.

[00:12:03] Doug Heikkinen: What has been the historical performance of CLOs across different market cycles, and what can advisors learn from that history?

[00:12:12] Bill Sokol: if you look over the last decade, CLOs have been actually the best performing fixed income asset class, certainly on a risk adjusted basis. And, even if on an absolute basis, much better performance versus investment grade corporates and treasury, so other investment grade fixed income.

So really, any exposure in a core bond portfolio would've been beneficial over the last several years. I think a lot of investors have focused, a lot of investors, especially new to the market, have focused on AAAs, AAA CLOs. Those have very low volatility, but they also have the lowest yield and return.

What we think is interesting is expanding a focus of a strategy to other parts of investment grade. because a lot of interesting opportunities can emerge if you can invest outside of AAA. for example, AA CLOs can, have provided much better returns than investment grade corporates, and the US ag, but with a lot lower volatility.

Single A CLOs have actually provided similar returns to high yield bonds and leveraged loans. But they've done so with a much higher credit quality and similar levels of volatility. So, you don't need a lot, you don't need to take a lot of risk in order to get that higher yield. We do think you need to take an active approach though, if you're gonna invest broadly. find those best opportunities in the market but also do so while managing risk.

So, it's really a top down and bottom up, process. On the CLOs we manage, we actually partnered with PineBridge, PineBridge Investments on, CLOI, which is our broad investment grade product, and CLOB, which invests in lower rated mezzanine CLOs.

PineBridge has decades of experience in the CLO LO market, and both of our ETFs are actually based on strategies that they've managed for institutional clients for many years.

[00:14:23] Doug Heikkinen: Fran. As Bill said you VanEck offers two actively managed ETFs that invest in CLOs, CLOI and CLOB. Can you walk us through each investment strategy and how they're managed?

[00:14:37] Fran Rodilosso: Sure Doug. CLOI is the first fund we launched. It's, coming up on a three year track record later this quarter. CLOI invests in the broad investment grade space in CLOs. Its mandate is really in the triple A, down to triple B space. There are built in parameters through which that fund will be managed.

You would see the combined AA and AA weights go below about 40% of that portfolio, and pretty rare to see them go below 50%. Currently, the fund is about 70% invested in AAA and AA, although, a little bit of the majority of that is in AA. that, that's the general mandate there. It's actively managed as Bill mentioned, sub-advised by PineBridge, who's got a very large and deep, deep in terms of experience.

CLO tranche investing team, we think that's really necessary for this market. So, CLOI, the investment grade tranches, broadly within the CLO universe, actively managed. CLOB, also actively managed, invests in what we call the broad mezzanine space in CLO. So, there's overlap. Mezzanine is basically all the debt beneath, triple A.

So, it's the double A, tranches down to double B. So, we go a little bit into the high yield tranches. So this is for investors, who have maybe a little more positive view on credit in general. want the yield pickup by, a lower average credit rating that would be involved in CLOB. same subadvisor in PineBridge.

similar approach in terms of moving up and down, what we call the capital stack. going higher quality, in risk off, type environments and taking advantage of opportunities in lower quality, when they arise. So that's CLOI, broad investment grade CLOB, mezzanine.

[00:16:51] Doug Heikkinen: What's the process for selecting securities and constructing the portfolio?

[00:16:56] Fran Rodilosso: Sure. the PineBridge process, which has been established for long before we launched these ETFs as four key steps. It starts with manager selection. As Bill mentioned, CLOs are actively managed themselves, and there are about 200 different managers out there in the space. needless to say, they're, not all equal.

And so PineBridge has a rigorous process for assessing those managers, their styles, their histories, et cetera. And we'll focus on the managers in whom they have the greatest faith in terms of managing, these portfolios for the best interest of, the, CLO, debt holders. so that's step one.

Step two is what they call re-underwriting the portfolio. Think about that as a real, bottom up analysis, loan level analysis of all the collateral underlying these CLOs of understanding all the documentation and protections that are there for debt holders. so just as analyzing a CLO, from any angle so they understand each issue that's out there. And what might happen should certain industries fall into stress. Should the credit environment shift, how close are these structures to, breaching certain covenants that might accelerate payments in some parts of the waterfall, starting at, the AAA, et cetera.

So that's super important. So the first two steps are really bottom up in their process. Managers, and then re-underwriting each, CLO. Then, the next important step is really portfolio construction. which is where that, bottom up meets their top down views on the credit cycle and interest rate cycle, et cetera, on the economy, and making some top down decisions on tranche allocation should be more risk off higher triple A and double A, or is it time to, gear the portfolio a little more toward the single A and triple B, say for this is the, in the CLOI example.

And the final step, of course, is risk monitoring. continually assessing both the top down views, and the bottom up analysis of all those portfolios. managing, with liquidity considerations, in mind as well. An important part of all of this is looking out for potential downgrades of CLO tranches, or potential opportunities where ones might get paid down or called if they're trading at, at, discounts.

Anyway, so that's, the last step is risk monitoring.

[00:19:37] Doug Heikkinen: Why do you believe active management is essential for investing in CLOs?

[00:19:43] Fran Rodilosso: this is a somewhat nuanced, asset class. So there's also pitfalls and opportunities, to maybe own the wrong tranche in a structure that might face a breach or that's poorly managed. From both the, alpha seeking and risk management point of view, we think active management is really important, in, in the bottom up sense. Also, top down, being able to navigate through the credit cycle and taking advantage of where the value is in general in the CLO market, we think is super important as well.

[00:20:20] Doug Heikkinen: Yeah. Are there structural benefits to using an actively managed ETF for CLO investing?

[00:20:26] Fran Rodilosso: definitely, the ETF structure itself, is, we think an appropriate vehicle will address some of the liquidity, in the asset class.

So it's always the first question we ask when you're going into an ETF structure with an asset class, is, for a daily liquidity vehicle, does the liquidity of the asset class, PR. match that. And, in this case, the answer was yes. You get all the same benefits of the ETF structure, and of course, cost efficiency, that comes in ETF structure. So that's super important. Actively manage. We think that's more of, the, a fundamental, purpose within the CLO universe. We think there's, too, many benefits to actively manage these portfolios. That just didn't make sense to us to do a passive approach to CLOs. And one, huge benefit is also, as I mentioned, the liquidity monitoring. As a nuanced universe, understanding what you can sell or buy at various times is going to be extremely important.

[00:21:33] Doug Heikkinen: Are there particular sectors or industries within the underlying loan market that you're closely monitoring for potential risks or opportunities?

[00:21:43] Fran Rodilosso: There are a couple ways of looking at that question. And, one is, we're monitoring credit markets in general. We and our partners in PineBridge.

and, always looking for, trends, pitfalls, et cetera. I will mention that each CLO itself, so they're buying PineBridge will be buying a tranche of a CLO structure. No sectors tend to make up more than 10% of these, portfolios with like tech and services, healthcare being some of the largest sectors in that space. so we're always doing a look through. Now, the point being you can't buy a CLO that has extreme exposure to any given sector.

So the idea of monitoring sectors isn't so much to make a call on which tranches to buy, but generally they're quite diversified. That being said, autos, cable, telecom, energy, metals, mining, those were all the sectors that like, PineBridge has identified, declining revenues last year. They'll look more closely at loans within those sectors that fall into the CLOs. Of course, over the last several years, lots of volatility in various parts of the healthcare sector as well. So as they do the bottom up analysis on CLO tranches, a big part of that is looking, not just at sectors, but at actual issuers and, loan level, assessments of, risks to those portfolios.

[00:23:16] Doug Heikkinen: How do you see the current interest rate environment impacting CLOs?

[00:23:21] Fran Rodilosso: yeah, it's a really good question, because, as Bill mentioned, CLOs are floating rate, the coupons reset quarterly, with SOFR effectively, and they're also, the underlying collateral is for the most part also floating rate, which by definition means like

changes in underlying interest rates aren't gonna have a large price impact on the universe. If rates fall this year as the market's, starting to factor in more and more, we will see coupons come down as these are floating rate instruments. I wouldn't call that a risk, a price risk, but it, depending upon what happens in other parts of the universe, it could change the relative value equation.

Bigger question is the reason for rates moving. And if rates come down more than we'd expect because we're in a very volatile credit environment, or the credit cycle has a major downturn, along with the economy, then you would see credit spreads. would've moved out pretty significantly.

And in that case, the entire credit universe, particular leveraged finance universe, probably would've faced a sell off, which, would have two effects. One, you know, if properly managed, something like CLOI would be higher triple A or AA as it is today, 70%. Those two tranches would be able to redeploy into some lower,

not without some price volatility in the ETF itself but then would still be able to redeploy into some of the lower rated tranches, at much more attractive spreads than, than more seniors today.

[00:25:06] Doug Heikkinen: What role does the strength of the US economy and corporate credit markets play in CO performance?

[00:25:16] Fran Rodilosso: The strength of the US economy and corporate credit markets in general, that really is meaningful. Of what's going to happen in the CLO market. As Bill mentioned earlier, CLOs are intrinsically tied to the broader leverage finance universe. And those, more leveraged low investment grade borrowers that make up the collateral for CLOs are very sensitive to overall changes in the economy.

Of course, sector differences will matter. but that is the driver of credit spreads really over at least long periods of time. it's the strength of the economy and the health of credit markets. all that being said, CLOs with their credit enhancements, especially the higher rate investment grade tranches, are still gonna be a lot less volatile than let's say, levered loans or high yield bonds. As you get down to single A and triple B, CLOs, as Bill mentioned, you could get, similar or even higher, volatility in the Triple Bs versus say, levered loans or high yield.

but the highest rated tranches really benefit in terms of lower volatility even, when the credit cycle changes versus the other parts of the leveraged finance universe.  

[00:26:32] Doug Heikkinen: What key risks should advisors be aware of when allocating to CLOs? And how do your ETFs, CLOI and CLOB help mitigate them? 

[00:26:43] Fran Rodilosso: yeah, that's, it's great. We actually to definitely focus on some of the risks in this market. Bill mentioned earlier, very few defaults ever, even through the global financial crisis in the investment grade CLO universe. So we think in terms of, okay, default risk is proven to be because the robustness of these structure is pretty low.

That does not mean, That CLO tranches won't face downgrade risk. So you know that's one important thing to consider that could impact prices are if there are downgrades in CLO tranches. And just generally speaking, there could be price volatility. As we mentioned, these are tied into what's going on in the levered loan market, really the high yield universe in general.

Just the higher rated tranches will experience lower price volatility, than the lower rated or the high yield CLO tranches. But both of those exist. And there are, if you're investing in single tranches, of course you're taking on all the other risks, the structural risk, the managers, how well they're taking care of the portfolios, whether or not they're favoring the equity holders over debt holders at some point.

That is where active management really plays an important role is, managing against those risks or even taking advantage of opportunities where, those risks might play out, in favor of certain tranches of CLOs.

[00:28:15] Doug Heikkinen: Bill, where do you see CLO ETFs fitting within an income allocation and a diversified investment portfolio?

[00:28:24] Bill Sokol: We think, we think if you're looking at investment grade CLOs, can be a very valuable addition to a core investment grade bond portfolio. if you look at the US AG, which is typically the benchmark that people look at. that's mostly made up of treasuries, corporates, and mortgages, but it doesn't include CLOs.

Your typical core bond allocation isn't gonna have CLOs. and adding CLOs can do a lot. You're gonna get the rate diversification, because of the floating rate nature of CLOs. yield pickup, of course, that we've discussed. and you get higher quality. CLOs have really negligible default risk when you're talking about investment grade tranches.

Over the last decade, you would've had better total return because of the yield pickup we've had lower volatility and lower. So adding on, CLOs to a core portfolio can really lead to better outcomes and of course, CLOs got the capital structure, so you can determine the term level of loss.

We lower rated mezzanine tranches, will provide higher yield, but with more volatility. But we think that type of strategy can really complement a high yield bond allocation. Again, you're gonna get higher quality, by adding CLOs. and again, over the last decade, better total returns and lower volatility.

We also think that. Lower rated mezzanine tranches can be attractive if an investor is looking to de-risk a leverage loan exposure, you're gonna maintain floating rate, exposure. You're still benefiting from the higher spreads that the asset class provides, but you don't have direct exposure to defaults.

and I think that might be particularly appealing right now if you think that the credit environment is becoming more uncertain as we look ahead.  

[00:30:31] Doug Heikkinen: All right, last one for you. If there's one key takeaway you'd like financial advisors to remember about CLOs and your ETFs, what would that be? 

[00:30:40] Bill Sokol: I think it's important to remember that CLOs, although they're new to a lot of investors, it's a well established, very large liquid asset class, and it's been through different market environments. It's been tested and the GFC and the Covid selloff, and they've performed very well. And I think investors who are new to the asset class can have confidence that these can really help to build more robust portfolios.

But as Fred mentioned, you really do need to approach this asset class actively. a broad approach, that isn't limited to a single rating, right? It allows you to find the best opportunities. You're not forced to buy something that isn't attractive. And you can better manage risk through different market environments.

[00:31:26] Doug Heikkinen: Super. That was incredibly interesting and thorough. Fran, bill, thank you so much for joining us.

To learn more about CLOs and VanEck, please visit vaneck.com. Please follow us for timely updates on X, LinkedIn and Facebook. All @Advisorpedia. For everyone at Advisorpedia, our producer, Tory Miller. And the Power Your Advice podcast team, this is Doug Heikkinen.