Collateralized loan obligations (CLOs) have been gaining wider prominence in markets in recent years. CLOs have historically offered a compelling combination of attractive yield relative to similarly rated bonds and loans, strong risk protection, and floating rate coupons that increase as rates rise. In this Q&A, we answer frequently asked questions about CLOs—including their structure and how they compare to other fixed income options—and specifically about the VanEck CLO ETF (CLOI).
Q: What is a CLO?
A: A CLO is a portfolio of predominantly senior secured bank loans that is securitized and actively managed. 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, lowest to highest in order of riskiness.
Subordination and Priority of CLO Tranches
Source: PineBridge Investments. This is not an offer to buy or sell, or recommendation to buy or sell any of the securities mentioned herein.
CLOs are actively managed vehicles—i.e., they have a reinvestment period during which the manager can buy and sell loans within the portfolio and reinvest within the parameters set forth by the governing documents. Managers can add value by reinvesting and positioning portfolios to increase returns in benign economic environments and protect against downside risk during weaker economic times.
Each CLO has a defined lifecycle in which collateral is purchased, managed, redeemed, and returned to investors. The standard lifecycle includes five stages:
- Warehousing (3-6 months): The manager purchases the initial collateral before the closing date.
- Ramp-up (1-6 months): Following the closing date, the manager purchases the remaining collateral to complete the original portfolio. After the ramp-up is complete, the manager also performs monthly tests to ensure the portfolio’s ability to cover its interest and principal payments.
- Reinvestment (1-5 years): Following the ramp-up period, the manager can reinvest all loan proceeds, either purchasing or selling bank loans to improve the portfolio’s credit quality.
- Non-call (first 0.5 to 2 years of reinvestment): Loan-tranche holders earn a per-tranche yield spread specified at closing, after which the majority equity-tranche holder can call or refinance the loan tranches.
- Repayment and deleveraging (1-4 years): As underlying loans are paid off, the manager pays down the loan tranches in order of seniority and distributes the remaining proceeds to the equity-tranche holders.
CLO Lifecycle
Source: VanEck. This is not an offer to buy or sell, or recommendation to buy or sell any of the securities mentioned herein.
Q: What are the benefits of CLOs?
A: Historically, CLOs have offered attractive yields relative to other corporate debt categories, including bank loans, high yield bonds, and investment grade bonds within the same rating category. CLOs are also floating-rate instruments, meaning they have low sensitivity to changes in interest rates. As interest rates rise or fall, CLO yields will move accordingly, and their prices have historically moved less than those of fixed-rate instruments. These characteristics can be advantageous to investors in diversified fixed income portfolios.
In addition, CLOs have built-in risk protection, which has historically helped them experience lower levels of principal loss when compared with corporate debt and other securitized products.
Q: What do you mean by “built-in risk protection”?
A: Cash flows are the lifeblood of a CLO. They determine the distribution of income and principal, which determines the return on investment. Cash flow distributions are paid sequentially starting with the senior-most tranche until each loan tranche has been paid its full distribution, a process commonly referred to as a “waterfall.” Equity-tranche holders absorb costs and receive the residual distributions once the costs have been paid.
Accordingly, the “built-in risk protection” of a CLO starts with the strength of its underlying collateral, i.e. the likelihood the collateral pool will continue to generate sufficient cash flow over the life of a CLO. Leveraged loans (the underlying collateral of CLOs) are senior secured, meaning they have the senior-most claim on all the issuer’s assets in the event of a bankruptcy. Historically, leveraged loans’ senior secured status has consistently led to lower default rates and higher recoveries compared to unsecured high-yield bonds. CLOs further reduce risk by creating diverse portfolios of leveraged loans—typically 150–250 borrowers—and actively managing that portfolio.
In addition to the attractive risk profile and active management of its underlying collateral, the structure of CLOs helps mitigate risk. For example, coverage tests are a vital mechanism to detect and correct collateral deterioration, which directly affects the allocation of cash flows. All CLOs have covenants that require the manager to test the portfolio’s ability to cover its interest and principal payments monthly. Among the many such tests, the most common are the interest coverage and overcollateralization tests. Interest coverage dictates that the income generated by the underlying pool of loans must be greater than the interest due on the outstanding debt in the CLO, while overcollateralization requires the principal amount of the underlying pool of loans to be greater than the principal amount of outstanding CLO tranches. If the tests come up short, the manager must take cash flows from the lowest debt and equity-tranche holders and divert them to retire the loan tranches in order of seniority.
Q: Didn’t CLOs play a role in the Global Financial Crisis?
A: CLOs are a type of structured credit, an asset class that includes subprime mortgage-backed securities and collateralized debt obligations, two market segments at the epicenter of the 2008 Global Financial Crisis. As a result, the perception exists among some investors and media professionals that all structured credit is inherently riskier than more traditional fixed income. Historical evidence, however, tells a much different story, especially for CLOs. For example, of the approximately $500B of U.S. CLOs issued from 1994-2009 and rated by S&P, only 0.88% experienced defaults. In the higher rated AAA and AA CLO tranches, there have been zero defaults.
This strong historical performance is a testament to the built-in risk protections of CLOs, many of which have only gotten stronger with age. In 2010, the second vintage of CLOs began (referred to as “CLO 2.0”). CLOs in the 2.0 vintage changed in response to the financial crisis by strengthening credit support and shortening the period in which loan interest and proceeds could be reinvested into additional loans.
The current vintage (“CLO 3.0”) began in 2014 and aimed to further reduce risk by eliminating high yield bonds and adhering to the Volcker Rule and other new regulations. In 2020, the Volcker Rule was further amended, and high yield bonds are now allowed back into CLOs. Currently, few CLOs allow for investments into high yield bonds, and those that do generally limit the exposure to 5%-10%. To compensate for the exposure to high yield, these CLOs have increased levels of subordination aimed to better protect debt tranches.
Q: How do CLOs compare to other fixed income options like bonds or loans?
A: CLOs have been tested through two major market crises. Through both the Global Financial Crisis and COVID-19 drawdown, the asset class ultimately experienced fewer defaults than corporate bonds of the same rating. We believe this resilience combined with the potential for upside returns makes the asset class compelling for long-term investors.
CLOs have low sensitivity to changes in interest rates due to their floating rate coupons, a characteristic that is similar to leveraged loans but with additional risk protections due to the CLO structure. Further, CLOs trade similarly to bonds and are generally not subject to the extended settlement times associated with loan settlement. These characteristics can be advantageous to investors in diversified fixed income portfolios.
Q: How big is the CLO market? Who are the main participants?
A: The global CLO market reached the $1T benchmark size in 2021. Assets under management were $875B for U.S. CLOs and €187B for European CLOs. CLOs play a very important role in global financing markets and account for more than 60% of the leveraged loan market, a dynamic that leads to robust annual issuance.
CLOs are issued and managed by asset managers. Ownership of CLOs varies by tranche. The least risky, senior-most tranches are mainly owned by insurance companies (which favor income-producing investments) as well as banks (which need high-quality capital to meet regulatory requirements). The equity tranche is the riskiest and offers potential upside and a degree of control.
Q: Is there liquidity in the CLO market?
A: Primary market issuance of CLOs hit a record level in 2021. In addition, there is a robust secondary market for CLOs, where trading volume has grown and shown resilience through volatile periods (e.g., the COVID-19 market drawdown). This is particularly true among investment grade tranches, where the secondary trading market has grown to $9B per month on average over the last two years.
Q: Are there benefits to active management in CLOs?
A: Replicating the main CLO benchmark is impossible due to the composition of the CLO market and the way CLOs trade. Further, given the tremendous diversity of CLO managers, vintages, underlying exposures and deal terms, there is significant opportunity for an experienced CLO tranche investor to add value.
Capturing opportunities in the CLO market requires an active approach and the expertise to perform bottom-up research on the individual bank loans in the underlying collateral pool. Some CLOs can have more than 200 issuers in their collateral pool. Accordingly, investment managers must have significant research capabilities to fully evaluate the underlying credit risk in each CLO. In addition, managers need relationships with primary and secondary market desks to appropriately trade and source opportunities.
At the same time, the importance of understanding a CLO’s structural characteristics cannot be underestimated. Two CLOs with the same exact collateral assets may produce varied performance due to different structural nuances. Additionally, the legal documentation that governs a typical CLO can be in excess of 300 pages. Extensive due diligence is needed on CLO managers to understand their style and process, and to determine whether they are more “debt friendly” or “equity friendly.”
Q: How do CLOs fit into my fixed income portfolio?
A: The enhanced yields and credit spreads provided by CLOs may help to maintain an attractive overall yield for an income focused portfolio. Although CLOs can introduce volatility if credit spreads widen, their historical default loss rate is extremely low, both on an absolute basis and relative to similarly rated bonds and loans.1 Thus, investors have been able to earn a higher level of income with significantly lower default risk.
The floating rate nature of CLOs means there is very little sensitivity to interest rates. Investors looking to shorten their overall duration might consider an allocation to CLOs from their investment grade or high yield fixed coupon investments. In addition, each CLO typically contains at least 150-250 unique issuer exposures. As high yield borrowers, these issuers won’t overlap with investment grade exposures, providing additional issuer diversification. Furthermore, overlap with high yield portfolios may also be relatively low, as a growing universe of issuers access funding only through the loan market.
Q: How can I access investment grade CLOs?
A: Until recently, it has been difficult for investors to add exposure to CLOs. The market is largely institutional, and investors such as banks, insurance companies and hedge funds often purchase CLOs directly or invest through institutional separate accounts, which often carry minimums of $50M to $100M. Actively managed multi-sector or core bond funds may include an allocation to CLOs, but investors cannot control the level of exposure and it may vary significantly over time. The VanEck CLO ETF (CLOI), launched in June 2022, provides access to investment grade CLOs, and may be an attractive way to efficiently access this market with the liquidity, transparency and low cost features of an ETF.
Q: What is the investment strategy of CLOI and how is it managed?
A: CLOI invests primarily in investment grade tranches of CLOs. The fund may invest up to 20% in BB rated CLOs, but will not invest in CLOs rated below BB-/Ba3 or equity tranches of CLOs. The ETF is actively managed by PineBridge Investments, the fund’s sub-adviser. CLOI aims to provide an enhanced yield by identifying the most attractive segments of the CLO market, while avoiding downgrades and default losses. PineBridge can move throughout the CLO capital structure to potentially add alpha, adding risk when there are opportunities and de-risking in periods of market volatility.
Q: What is the process used to select securities and construct the portfolio?
A: PineBridge draws on its decades of CLO market experience and the credit expertise of its leveraged finance team to identify credit and CLO manager risk within a CLO. The process is summarized below:
- CLO Manager Due Diligence: Based on a systematic due diligence process, PineBridge classifies CLO managers, and focuses investments on those with an established process and team.
- Re-Underwrite CLO: PineBridge collects and analyzes fundamental loan-level data using its proprietary credit platform, which drives portfolio credit analysis, risk measurement and optimization. The team reviews each CLO’s structure and documentation, which—combined with the collateral analysis and stress-test analysis—is the basis of the investment analysis.
- Construct Portfolio: Portfolios are constructed by PineBridge using both bottom-up deal selection from the re-underwriting process and a top-down overlay that incorporates the group’s credit views.
- Risk Monitoring: There is ongoing compliance and risk monitoring, as well as regular reviews of the portfolio and CLO-specific metrics that can result in rebalancing. Various portfolio and performance metrics act as “credit review triggers” and form the basis of the sell discipline.
CLOI is managed to avoid downgrade and default risk, which is done by stressing CLO tranche cashflows through loan-by-loan and portfolio level changes in default rates, recovery rates and interest rates, among other factors. The portfolio is monitored for early warnings that might signal a change in fundamentals.
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DISCLOSURES
1 Source: S&P Global Ratings.
This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. 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. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.
An investment in the VanEck CLO ETF (CLOI) may be subject to risks which include, among others, Collateralized Loan Obligations (CLO), debt securities, LIBOR Replacement, foreign currency, foreign securities, investment focus, newly-issued securities, extended settlement, affiliated fund, management, derivatives, cash transactions, market, Sub-Adviser, operational, authorized participant concentration, new fund, absence of prior active market, trading issues, fund shares trading, premium/discount, liquidity of fund shares, non-diversified, and seed investor risks. The Fund may also be subject 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
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.
