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CLOs Belong in Your Core: Q&A with Laila Kollmorgen

June 27, 2024

Read Time 9 MIN

CLOs have historically offered attractive yield premiums with robust risk profiles. It’s time to include them in your core bond allocation.

PineBridge Investments’ Laila Kollmorgen discusses the growing appeal of CLOs and the importance of active management in this Q&A. Pinebridge sub-advises the actively managed VanEck CLO ETF (CLOI).

For those who are not overly familiar with the asset class, the first thing investors need to understand about collateralized loan obligations (CLOs) is the collateral: they are a securitized pool of senior secured loans, also known as leveraged loans. CLOs hold floating-rate, secured loans, which have seniority over other claimants in the event of an insolvency. One of the key differences between a CLO and other types of securitizations is that a CLO is an actively managed vehicle, typically having a 5-year reinvestment period and 2-year non-call period during which the CLO manager is not allowed to redeem or refinance the tranches of the CLO. Given that the CLO manager is responsible for portfolio construction, security selection and risk management, their role is key to how the CLO performs over the lifetime of the deal.

CLOs are composed of multiple tranches of debt, each with different seniorities, and an equity tranche. The cash flows from the underlying loan portfolio are distributed sequentially, starting with the most senior tranche. This hierarchy provides protection to senior tranche investors, as losses are first absorbed by equity tranche holders.

All About the Cash Flows: Understanding How a CLO Works

All About the Cashflows: Understanding How a CLO Works

Source: PineBridge Investments. This is not an offer to buy or sell, or recommendation to buy or sell any of the securities mentioned herein.

One of the biggest misconceptions about CLOs is that they are inherently risky. In fact, the opposite is true. CLOs, structurally, have built-in risk protections that have historically helped them experience lower levels of principal loss when compared with corporate debt and other securitized products. This built-in risk protection comes in many forms, including active management, credit support, covenants and collateral requirements, and excess spread.

CLOs Benefit from Multiple Structural Protections

Active Management CLO managers analyze issuers and apply sector expertise to construct portfolios. Fees are generally linked to performance.
Credit Support Subordinated tranches absorb losses first.
Credit Support Subordinated tranches absorb losses first.
Covenants & Collateral Requirements CLOs have features that are protective of debt tranches:
  • CLO portfolios are subject to quality and diversity tests that must be met
  • Interest cash flows are diverted to pay off senior tranches if tests such as interest coverage or overcollateralization are not met
Excess Spread Excess income vs interest paid on debt tranches provides protection in case coverage tests are not met, which can be used to buy additional assets or pay down notes.

These structural protections have been tested through two major market crises. Many investors are surprised to learn that through both the Global Financial Crisis and COVID-19 drawdown, the asset class ultimately experienced fewer defaults than corporate bonds of the same rating—this resilience combined with the potential for upside returns makes the asset class compelling for long-term minded investors.

Historically, CLOs have offered a higher yield relative to other corporate debt categories, including bank loans, high yield bonds, and investment grade bonds. Once investors start to understand the attractive risk profile of CLOs, I’m often asked how this is possible. If it is less risky and has historically experienced fewer defaults, why does a CLO tranche consistently have a higher spread compared to similarly rated corporate bonds?

The first thing I point out is that CLOs are complex, which adds a premium. In addition, due to regulatory changes following the 2008 Global Financial Crisis, large, regulated investors like banks and insurance companies had the minimum risk based capital requirements raised for CLOs, meaning that this investor base requires a higher spread to invest in the asset class. And this raises another common misconception about CLOs—many investors think they are illiquid. We’ve all read the articles about the illiquidity in the US Treasury and IG bond markets. However, the difference for CLOs is that the asset class doesn’t rely on 10 market makers to provide liquidity. CLOs, like all securitizations, trade in an auction process. Lists are sent out typically for next day trading. This allows time for investors like us to analyze the deals and determine if we want to participate in the auction. Investment grade tranches typically get a significant number of bids, and even high yield down to single B tranches will typically get multiple bids. In times of market stress, fewer bids may be received (as would be anticipated in even Treasury and IG markets), but the difference is that in the CLO market, many of the bids are coming from end accounts and not a dealer.

While CLOs are floating rate instruments, meaning they have low sensitivity to changes in interest rates, prices do change as a result of spread duration. As interest rates rise or fall, CLO yields and prices will move accordingly. However, because CLO spread duration is lower than a typical IG, CLO prices have historically moved less. These characteristics can be advantageous to investors in diversified fixed income portfolios.

The Attractive Risk-Adjusted Returns of CLOs vs Other Asset Classes (10 Years as of 3/31/2024)

The Attractive Risk-Adjusted Returns of CLOs vs Other Asset Classes (10 Years as of 3/31/2024)

Rating CLOs >AAA Rated CLOs A Rated CLOs A Rated CLOs BBB Rated CLOs BB Rated CLOs US IG US HY Leveraged Loans US IG FRNs Agg
Return 3.65 2.99 3.58 4.33 5.69 8.9 2.67 4.36 4.11 2.57 1.57
Sharpe Ratio 0.6 0.7 0.53 0.52 0.49 0.53 0.21 0.41 0.55 0.45 0.04

Source: Morningstar. CLOs represented by J.P. Morgan CLO Index; AAA Rated CLOs represented by J.P. Morgan CLO AAA Index, AA Rated CLOs represented by J.P. Morgan CLO AA Index, A Rated CLOs represented by J.P. Morgan CLO A Index, BBB Rated CLOs represented by J.P. Morgan CLO BBB Index, BB Rated CLOs represented by J.P. Morgan CLO BB Index, US IG represented by ICE BofA US Corporate Index, US HY represented by ICE BofA US High Yield Index, Agg is represented by the ICE BofA US Broad Market, US IG FRNs represented by MVIS US Investment Grade Floating Rate Note Index, Leveraged Loans represented by Morningstar LSTA US Leveraged Loan 100 Index. See index descriptions at the end of this presentation. Past performance is not indicative of future results. This is not an offer to buy or sell, or recommendation to buy or sell any of the securities mentioned herein.

As I said earlier, CLOs are complex investments. Due to the significant diversity of CLO managers, vintages, underlying exposures and deal documentation, replicating the main CLO benchmark is impossible due to the idiosyncratic nature of CLOs.

Capturing opportunities in the CLO market requires an active approach and the expertise to perform bottoms-up research on the individual bank loans in the underlying collateral pool. Most 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. There’s no substitute for deep CLO tranche management experience, which provides the combination of skills, practice, tactical and strategic savvy, adjustment-making, and chronological perspective needed in this complicated asset class.

What is PineBridge’s experience in the CLO space?

PineBridge is the subadvisor of the VanEck CLO ETF (CLOI). For those not familiar with PineBridge, we are a private, global asset manager, managing approximately $168B in assets, with more than 700 employees globally (~230 of which are investment professionals) located in 24 office locations worldwide (as of 3/31/2024).

Having a global footprint, we develop our top-down views through monthly investment meetings discussing rates, FX, multi-asset, fixed income and leveraged finance. The majority of our assets are in fixed income and I sit within the leveraged finance group, where we manage approximately $28B in AUM (as of 3/31/2024), spread across high yield, leveraged loans, the CLOs that we issue and manage ourselves and the business line that I run, CLO tranche investing. I joined PineBridge nine years ago to start the business line as part of the firm’s Leveraged Finance Group. I was already familiar with PineBridge’s CLO platform, having invested in both their US and European CLOs.

It’s important to understand why being part of the leveraged finance team is so important. Pinebridge has 15 credit analysts, focused on the high yield and leveraged loan markets in the US and Europe. It's this bottoms-up analysis that is behind the credit selection in our high yield, loan, and CLO strategies, and, ultimately, behind each CLO tranche investment made. PineBridge has been issuing CLOs since 1999 and European CLOs since 2006. It’s imperative to understand the dynamics between the high yield, leveraged loan and CLO markets to appreciate the technical and fundamental aspects of how these markets are linked.

When it comes to CLOs, our main focus is on managing downgrade risk. We monitor CLO-specific metrics to detect early signs of credit deterioration, allowing us to address potential downgrades proactively. Using the entire capital stack in a CLO, we incorporate insights from our global team to build and position portfolios strategically. This approach helps us navigate market volatility.

PineBridge CLO Tranche Investment Philosophy

PineBridge CLO Tranche Investment Philosophy

Source: PineBridge Investments. For illustrative purposes only. Any views represent the opinion of the investment manager and are subject to change. Risk process and frequency subject to change at the discretion of management as warranted by market volatility or other considerations. Past performance is not indicative of future results.

We believe CLOs should be part of an investor’s core bond portfolio. As the chart below shows, adding anywhere from a 10-30% CLO allocation to a broad market allocation may increase the yield in a portfolio, increases the Sharpe ratio and decreases the potential max drawdown.

Adding CLOs Provided Better Outcomes (as of 3/31/2024)

Adding CLOs Provided Better Outcomes (as of 3/31/2024)

10Y Stats Agg Agg+10% CLO Agg+20% CLO Agg+30% CLO CLOs
Sharpe Ratio 0.04 0.09 0.15 0.22 0.6
Max Drawdown -17.38 -15.58 -13.96 -12.42 -8.68

And Better Yields (as of 3/31/2024)

And Better Yields (as of 3/31/2024)

Source: JP Morgan and ICE Data Services. CLOs refers to the J.P. Morgan Collateralized Loan Obligation Index (CLOIE) and Agg refers to the ICE BofA US Broad Market Index. CLO Yield to Worst represents yield to call for premium priced securities or to maturity when priced at a discount to par based on forward reference rates. See index descriptions at the end of this presentation. Past performance is not indicative of future results. This is not an offer to buy or sell, or recommendation to buy or sell any of the securities mentioned herein. For illustrative purposes only.

The CLO market is largely institutional, with banks, insurance companies and hedge funds often purchasing CLOs directly or through institutional separate accounts that may carry minimums of $50M or more. This may make access difficult for many investors.

Investing in CLOs with VanEck

The VanEck CLO ETF (CLOI), subadvised by PineBridge, may offer an attractive way for investors to efficiently access this market with the liquidity, transparency and low cost features of an ETF. CLOI invests primarily in investment grade CLO tranches and may invest up to 20% in BB-rated CLOs (but will not invest in CLOs rated below BB-/Ba3 or equity tranches of CLOs).

CLOI aims to provide an enhanced yield by identifying the most attractive segments of the CLO market, while avoiding downgrades and default losses. Through our active management, we 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.

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IMPORTANT DISCLOSURES

This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities, financial instruments or digital assets mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, tax advice, or any call to action. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results, are for illustrative purposes only, are valid as of the date of this communication, and are subject to change without notice. Actual future performance of any assets or industries mentioned are unknown. 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. VanEck does not guarantee the accuracy of third party data. The information herein represents the opinion of the speaker(s), but not necessarily those of VanEck or its other employees.

The Fund’s benchmark is the JP Morgan CLOIE Index which is the first rules-based total return benchmark for broadly-syndicated, arbitrage US CLO debt. Information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The Index is used with permission. The index may not be copied, used or distributed without J.P. Morgan’s written approval. © 2024, J.P. Morgan Chase & Co. All rights reserved. Index performance is not representative of Fund performance. It is not possible to invest directly in an index.

An investment in the VanEck CLO ETF (CLOI) may be subject to risks which include, but are not limited to, risks related to Collateralized Loan Obligations (CLO), debt securities, LIBOR Replacement, foreign currency, foreign securities, investment focus, newly-issued securities, extended settlement, affiliated fund investment, management and capital preservation, derivatives, cash transactions, market, Sub-Adviser, operational, authorized participant concentration, no guarantee of active trading market, trading issues, fund shares trading, premium/discount, liquidity of fund shares, non-diversified, and seed investor risks, all of which may adversely affect the Fund. Investments in debt securities may expose the Fund to other risks, such as risks related 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 impact the Fund’s performance. Derivatives may involve certain costs and risks such as liquidity, interest rate, and the risk that a position could not be closed when most advantageous.

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.

© Van Eck Securities Corporation, Distributor, a wholly owned subsidiary of Van Eck Associates Corporation.

IMPORTANT DISCLOSURES

This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities, financial instruments or digital assets mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, tax advice, or any call to action. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results, are for illustrative purposes only, are valid as of the date of this communication, and are subject to change without notice. Actual future performance of any assets or industries mentioned are unknown. 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. VanEck does not guarantee the accuracy of third party data. The information herein represents the opinion of the speaker(s), but not necessarily those of VanEck or its other employees.

The Fund’s benchmark is the JP Morgan CLOIE Index which is the first rules-based total return benchmark for broadly-syndicated, arbitrage US CLO debt. Information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The Index is used with permission. The index may not be copied, used or distributed without J.P. Morgan’s written approval. © 2024, J.P. Morgan Chase & Co. All rights reserved. Index performance is not representative of Fund performance. It is not possible to invest directly in an index.

An investment in the VanEck CLO ETF (CLOI) may be subject to risks which include, but are not limited to, risks related to Collateralized Loan Obligations (CLO), debt securities, LIBOR Replacement, foreign currency, foreign securities, investment focus, newly-issued securities, extended settlement, affiliated fund investment, management and capital preservation, derivatives, cash transactions, market, Sub-Adviser, operational, authorized participant concentration, no guarantee of active trading market, trading issues, fund shares trading, premium/discount, liquidity of fund shares, non-diversified, and seed investor risks, all of which may adversely affect the Fund. Investments in debt securities may expose the Fund to other risks, such as risks related 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 impact the Fund’s performance. Derivatives may involve certain costs and risks such as liquidity, interest rate, and the risk that a position could not be closed when most advantageous.

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.

© Van Eck Securities Corporation, Distributor, a wholly owned subsidiary of Van Eck Associates Corporation.