In the latest episode of our Global Perspectives podcast series, Portfolio Managers Nick Childs and Jessica Shill discuss why collateralized loan obligations (CLOs) deserve a closer look in today’s environment given their low interest rate sensitivity, attractive yields and diversification benefits.
- The current mix of low yields, high inflation and rising interest rates should prompt investors to be more thoughtful about how – not if – they should take bond exposure.
- Floating-rate securities such as CLOs can help diversify a portfolio of government and corporate bonds while offering competitive yields and lower sensitivity to rising rates.
- Although the CLO market has become accessible to a wider range of investors in recent years, we believe a rigorous due diligence process remains a critical component of investing in the asset class.
Adam Hetts: Welcome to Global Perspectives. And today, we get to talk CLOs with Nick Childs and Jessica Shill. Nick and Jess are both Fixed Income Portfolio Managers with a focus on securitized markets.
And it’ll be good to dig into CLOs, because ever since 2008, I think people’s eyes can glaze over when securitized acronyms get thrown around, like MBS and CMO and CDO, CDS, CDO-squared. And not only are CLOs a bit unique but they’ve become a popular solution in this low-rate environment and they’re worth a look on their own.
So here we are. Nick, Jess, thanks for joining us.
Nick Childs: Thanks for having us, Adam.
Adam Hetts: Nick, we’ll start with you and start with what I just mentioned and that sea of securitized acronyms. What exactly are CLOs? And why is this the place where you’re focused right now?
Nick Childs: As an industry, I think we do a fantastic job of confusing investors with acronyms. All of these are securitization. So let us take a quick moment and review what we mean by securitization in the debt or the bond market.
Securitizations are financial instruments created via the pooling of assets such as home mortgages, auto loans or other assets that generate cash flow. These are bundled and sold to investors, who collect income from the underlying loans or assets. So when you think about collateralized loan obligations, these are managed portfolios of bank loans. So bank loans, a different asset than perhaps autos and mortgages, but a similar process within the securitization market.
These are then tranched so that you get varying credit risk and thus varying credit ratings directly in the market. They are also floating-rate instruments, and they are floating rate because bank loans in and of themselves are floating rate. High-quality floating rate bonds are difficult to find in the U.S. market. And so, traditionally, investors have favored the bank loan market as that surrogate but had to accept lower credit quality to do so.
So with CLOs, investors can achieve floating-rate exposure from AAA or even BBB rated assets. CLOs can be an attractive addition to diversifying a portfolio of government and corporate bonds and complement other securitized holdings such as mortgage-backed securities.
Hetts: So then as common as securitization is, why are we having this conversation today on CLOs, after already a decade or more of low rates? And why haven’t we been talking about CLOs for a long time already?
Childs: I think CLOs have been talked about for a long time, but they’ve been talked about from an institutional perspective. So traditional investors in CLOs have been large institutions. Broadly, the minimum denomination in which you can buy is $250,000. Today, there is access out there in the marketplace for your retail investors or other investors to get involved in the space. Additionally, the marketplace has grown to over $1 trillion in size, creating an even more possible and liquid asset allocation to the CLO marketplace.
Hetts: And then Jess, if we can bring you in. So Nick mentioned that these are, in a way, bundles of bank loans. So then I think a lot of people are pretty familiar with the bank loans asset class or category. So how are CLOs different from an investment personality perspective, as an asset class, than traditional bank loans?
Jessica Shill: So bank loans are essentially the building blocks of CLOs, and they are issued by banks to smaller companies that can’t typically access the bond markets, the high-yield bond market. Loans carry credit ratings of below investment grade and are often used by companies to refinance their existing debt, to make an acquisition or recapitalize their company.
Both CLOs and bank loans are floating rate. Now, how they differ is that CLOs can provide investment-grade ratings due to the inherent diversity gained from holding that portfolio of different loans. There are typically 300 to 500 loans in any given CLO. CLOs also have additional credit enhancement as a result of their unique structure.
So the CLO issuer is required to periodically ensure that there is more than enough capital in the underlying loan portfolio to support the interest in principal for each tranche of the CLO, starting with the AAA tranche and working down the rating tiers to either the BB or B tranche. If at any point in time there is insufficient collateral, the cash flows that are intended for the lower-rated tranches are diverted to the highest-rated tranche.
So during a time of stress, the AAA tranche could actually be repaid sooner than expected as opposed to later due to that cash flow diversion. And to put it differently, in times of market stress, the credit quality of the higher-rated tranches generally improves rather than deteriorates.
Hetts: OK, that’s helpful. So when you take bank loans but bundle a few hundred, I think you said 300 to 500, and add some credit enhancements, now we’re talking investment-grade fixed income.
So then as far as stress periods, given that we’re talking investment grade, in the 2008 crisis, a lot of those other three-letter acronyms in fixed income securitization became four-letter words as those markets imploded and losses mounted. So how did CLOs perform in that Global Financial Crisis? And then, how about more recently, during the stress we had in March of 2020?
Shill: So when bond market volatility peaked during the COVID-19 crisis, which was the most severe liquidity crisis since the 2008, trading volumes in many fixed income markets fell. Meanwhile, in the CLO market, volumes surged, particularly in the AAA tranche, and March of 2020 set a new monthly record for the asset class’ trading volumes.
When looking at how they have performed from a principal standpoint, CLOs have had certainly lower default rates than the broader loan market. This has ranged from 1% to 2% since 2015. Meanwhile, the peak in loan defaults was in 2014, and that reached 4.5%.
CLO defaults, in contrast, peaked in 2002 at near 0.4% and have either been zero or negligible since. Simply put, neither the loan default rate nor the loan loss rate, even during the GFC, has come close to the levels required to impair investment-grade CLOs.
To incur a default at the AAA level, it would take roughly an 80% annualized default rate on those underlying loans over the life of the AAA bond to incur principal loss. So that’s obviously an incredibly Draconian scenario and one that we have not even come close to realizing historically.
Hetts: OK, thanks, Jess. And maybe stress periods aside, on the more optimistic front, Nick, when equity markets are doing well and rates are rising because of broader economic health, how has that floating-rate component of CLOs performed?
Childs: I think that’s a great question. While most investors instinctually feel that rising interest rates are bad for bonds, we’d say the opposite is true, or often true, for floating rate bonds; in particular, higher-quality floating rate bonds.
So in an environment like today where yields are low, inflation is high and interest rates are expected to rise, investors need to be a bit more thoughtful about how, not if, they should take bond exposure. So floating-rate securities such as CLOs deserve certainly a closer look given their low interest rate sensitivity, attractive yields, as well as diversification benefits.
If you look at periods, so look at, as an example, periods between December 2017 and the end of November 2018, when the Fed raised interest rates 125 basis points, the Agg, the U.S. Aggregate Index, lost around 160 basis points, the shorter duration Bloomberg 1-3 Year U.S. Government/Credit Index gained 80 basis points, while the CLO market, as per the JP Morgan AAA CLO Index, rose around 255 basis points. So a substantial pickup versus the Aggregate Index, while you’re still maintaining a very high or higher credit quality fixed income portfolio.
Lastly, the correlation between the returns of AAA CLOs and the returns of major equity markets and fixed income assets is low to negative. So when we think about fixed income, what’s really important for us, and I think most clients are also thinking of, frankly, is the diversification benefit within portfolios.
Hetts: OK. So then overall, we’re talking about good performance during rising rates, competitive yields, all pretty attractive in this environment. So Nick, how about the client conversations you’ve been having? Who are buying CLOs? And can you share any common questions or objections you’ve had to work through in those client meetings recently?
Childs: Historically, most CLOs were privately placed into the hands of large institutional investors. But as the CLO market has grown, more opportunities for investors to include CLOs in their portfolios are emerging. CLOs are not a new asset class but their availability to a wider range of fixed income investors now is.
So CLOs within the A and AAA ratings offer premium over similar-rated corporate bonds. Over the last five years, AAA CLOs have offered nearly two times the spread over Treasuries that similarly rated corporate bonds have. And in the A-rated category, they’ve paid over 2.5 times the spread.1
When absolute yield levels across many fixed income markets are low, the yields on CLOs can look attractive given their credit quality and given where we are in the market environment.
Hetts: OK. And then Jess, if we can close out with you. So you guys are navigating, what Nick is explaining, a pretty attractive space in the time of rising rates, inflation fears, equity volatility. What do you think CLO investors should be most focused on right now? And what do you think is the most important nuance in the asset class going forward?
Shill: I think it’s important to recognize that this is a massive market and not anyone can just go out and invest in a CLO. It takes a lot of resources with deep CLO experience and the ability to pay for specific software programs to help those managers slice and dice all of the market data out there.
Thus, we think it is incredibly important to have a rigorous due diligence process and a fundamental understanding of the underlying loans of a CLO portfolio when investing in the asset class. There are over 110 issuers in the CLO market, so it is very important to differentiate between these platforms.
Additionally there, another nuance of the market is the variability of tenor. There is zero duration in the CLO market, but there is a range of weighted average lives [WALs]. We don’t believe that you are adequately compensated for buying those bonds with longer WALs, so it is important to understand the average life of the bond that you are buying and make sure you are getting adequately compensated for those longer bonds.
Hetts: All right. Nick, Jess, thanks again. Obviously, an important space to be considering given the environment with CLOs, so appreciate all the insight there.
Childs: Thank you.
Hetts: And for our listeners, thanks for joining. And, as always, the views of Janus Henderson’s other investment teams and thought leaders are freely available within the Insights section of our websites. And meanwhile, we’ll look forward to bringing you more Global Perspectives in the near future.
1Source: Bloomberg, as of 10 February 2022. Bloomberg rating-category subindices option-adjusted spread for corporate bonds, JPMorgan discount margin indices for CLOs. Five-year average spread over Treasuries: AAA CLOs = 1.22, AAA Corporates = 0.64, A CLOs = 2.38, A Corporates = 0.90. Note: spread is the additional yield provided over comparable U.S. Treasuries.
Bank loans often involve borrowers with low credit ratings whose financial conditions are troubled or uncertain, including companies that are highly leveraged or in bankruptcy proceedings.
Basis Point (bp) equals 1/100 of a percentage point. 100 bps = 1%
Bloomberg 1-3 Year U.S. Government/Credit Index measures Treasuries, government-related issues and corporates with maturity between 1-3 years.
Bloomberg U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market.
Collateralized Loan Obligations (CLOs) are debt securities issued in different tranches, with varying degrees of risk, and backed by an underlying portfolio consisting primarily of below investment grade corporate loans. The return of principal is not guaranteed, and prices may decline if payments are not made timely or credit strength weakens. CLOs are subject to liquidity risk, interest rate risk, credit risk, call risk and the risk of default of the underlying assets.
Correlation measures the degree to which two variables move in relation to each other. A value of 1.0 implies movement in parallel, -1.0 implies movement in opposite directions, and 0.0 implies no relationship.
Credit quality ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest).
Duration measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.
J.P. Morgan CLO AAA Index is designed to track the AAA-rated components of the USD-denominated, broadly syndicated CLO market.
Loan Loss Rate: losses due to uncollectible loans and loan payments
Option-Adjusted Spread (OAS) measures the spread between a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option.
Weighted Average Life (WAL): the average length of time that each dollar of unpaid principal on a loan remains outstanding.