Why We Like CLOs Amid a Fed Pause
May 03, 2023
Read Time 7 MIN
With the Fed appearing to indicate a possible pause on additional rate increases after its latest hike, and the market still predicting rate cuts later this year, is there still a case for investing in collateralized loan obligations (CLOs)?
We believe the historical spread pickup, low loss rates and diversification potential of CLOs make them attractive as a strategic allocation within a bond portfolio through market cycles. In the current environment, we think CLOs are particularly compelling, even as expectations for further rate hikes diminishes. Yields and spreads on CLO debt remain extremely attractive, and a new rate environment could actually bring additional return potential and the opportunity for above-coupon returns.
Go Where the Yield is
A Fed pause means that CLO coupons will likely continue to reset at current high levels for some time, and the yields offered will continue to exceed what can be found in longer duration credit asset classes in the absence of a substantial increase in long-term rates. Currently, CLOs have a yield of approximately 6.5%, versus 5.2% for investment grade corporate bonds and 4.5% on “core” bonds.1
The yield on CLOs assumes realization of the forward rates implied by the market, which currently reflects a decline in short-term rates in the near future. In other words, the yield already reflects declining short-term rates and therefore lower coupons in the future, which may or may not actually happen.
Investors today are understandably comparing the yields on short-term, credit-risk free instruments like Treasury bills (T-bills) which are currently attractive for the same reason that CLO coupons are high. Although these rates may be attractive as a cash alternative, such a short horizon introduces reinvestment risk and we believe a longer-term time horizon continues to favor CLOs within a bond portfolio given the long-term yield potential thanks to the significant spread CLOs provide. Although CLOs have coupons that reset periodically, they have an expected life that is longer–currently 3.8 years. An apples-to-apples comparison to T-bills must therefore assume reinvestment every three months over a 3.8 year period at market implied rates, and as shown below, CLOs currently provide a significant yield pickup over the period.
CLOs Provide a Significant Yield Pickup compared to T-Bills and IG Corporates
Source: J.P. Morgan and VanEck Research. CLOs is represented by the J.P. Morgan CLO Index; IG Corporates (Maturity Matched) represents the mid yield of USD denominated US investment grade corporates, interpolated at a maturity of 3.8 years; 3m T-bills (Reinvested) is represented by the return on 3-month T-bills invested on 4/28/2023 and reinvested every 3 months for 3.8 years based on market implied rates.
Uncertainty is Priced Into CLO Spreads
The CLO yield advantage comes from the spread, and with that comes the risk of spread widening, even though investment grade CLOs are extremely well insulated from credit loss. But spreads on CLOs are currently very attractive relative to their historical average and seem to be pricing in a higher degree of uncertainty compared to investment grade and high yield corporate bonds, which are actually tight relative to their historical average. We believe that is another reason why the current environment favors CLOs. Spread widening is certainly possible in all credit sensitive asset classes, but we believe investment grade CLO investors are currently well compensated for that risk.
CLO Yield and Spread
(12/31/2011 to 4/28/2023)
Source: J.P. Morgan. Based on J.P. Morgan CLO Index. “DM” represents developed markets. This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities mentioned herein. See index descriptions at the end of presentation. Past performance not indicative of future results. As of April 28, 2023.
Changing Rate Environment May Create Opportunity
In addition to attractive value from both a yield and spread perspective, we believe that if and when we do actually see a Fed pivot, such an environment may actually provide extremely compelling opportunities in the CLO market, particularly for active tranche managers. A cut in rates will likely occur as a result of an economic slowdown, which would likely coincide a general widening of credit spreads. As spreads recover following a Fed pivot, there may be opportunities for outperformance in portfolios that can opportunistically add exposure to lower-rated tranches at attractive entry points.
Further, the embedded optionality in CLO debt tranches also has the potential to add value in this environment. CLO equity holders have the option to to redeem, reset or refinance a deal at par prior to a CLO’s final legal maturity after the end of the non-call period, which is typically about two years after issuance.
CLOs Typically Have a Final Maturity of up to 11-13 Years, but a Shorter Expected Life Due to Loan Amortization
Currently, loan prices are below par and the cost of refinancing a CLO is high (reflecting both the increase in Libor/SOFR and wider spreads over the past year). If a loan portfolio was liquidated, it may not be enough to pay off the CLO debt tranches with adequate return to the equity holders. Therefore, few deals are getting called or refinanced in the current market. A decrease in rates and/or tighter CLO liability spreads, as well as a recovery in loan prices, could all be expected to drive an increase in call activity. As of March 31, 2023, loan prices were in the mid-90s and CLO average prices by rating are shown below.
|Indices||Price||Yield to Worst||Wtd. Avg. Life (to Worst)|
Source: J.P. Morgan as of 4/28/2023.
The opportunity to buy tranches at a steep discount, especially in the lower rating categories, and potentially benefit from a call that occurs years before final maturity as market conditions change can provide significant upside potential. For example, a BB tranche purchased at 85 represents a yield of 14% over the life of the deal, currently assumed to be about seven years. Because the tranche is priced under par, “to worst” measures like yield-to-worst assume no call will occur. If market conditions change and that CLO gets called at par before seven years (and potentially way before that), there is significant upside potential and an investor may ultimately realize a return of much greater than 14%.
CLOI is Uniquely Positioned to Take Advantage of These Opportunities:
The key is to find CLOs that are attractively priced, including those more likely to be called, and to have flexibility to invest throughout the CLOs capital structure to find the best opportunities. The ability to understand all of the various drivers of CLO risk is key in assessing the relative value of a tranche. PineBridge has decades of expertise in the CLO market and takes an active, high conviction approach to investing in CLO tranches. The VanEck CLO ETF (CLOI) is actively managed and based on a strategy that PineBridge has managed for years for its institutional clients, and is now available to all investors with the transparency, liquidity and cost benefits of an ETF.
Average Annual Total Returns (%) as of March 31, 2023
|1 Month*||3 Month*||YTD||1 Year||3 Year||5 Year||10 Year||LIFE
|CLOI (Share Price)||-0.31||2.28||2.28||--||--||--||--||5.91|
|J.P. Morgan Collateralized Loan Obligation Index||-0.23||1.98||1.98||--||--||--||--||4.72|
* Returns less than one year are not annualized.
The performance data quoted represents past performance. Past performance is not a guarantee of future results. Investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Performance may be lower or higher than performance data quoted. Please call 800.826.2333 or visit vaneck.com for performance current to the most recent month ended.
The gross expense ratio for CLOI is 0.4%. CLOI Fees & Expenses: Van Eck Associates Corporation (the “Adviser”) will pay all expenses of the Fund, except for the fee payment under the investment management agreement, acquired fund fees and expenses, interest expense, offering costs, trading expenses, taxes and extraordinary expenses. Notwithstanding the foregoing, the Adviser has agreed to pay the offering costs until at least May 1, 2024.
The "Net Asset Value" (NAV) of a Fund is determined at the close of each business day, and represents the dollar value of one share of the fund; it is calculated by taking the total assets of the fund, subtracting total liabilities, and dividing by the total number of shares outstanding. The NAV is not necessarily the same as the ETF 's intraday trading value. Investors should not expect to buy or sell shares at NAV.
1 Source: J.P. Morgan and ICE Data Indices as of 4/26/2023. CLOs represented by the J.P. Morgan CLO Index; Investment grade corporate bonds represented by the ICE BofA US Corporate Index; Core bonds represented by the ICE BofA US Broad Market Index.
J.P. Morgan CLO Index tracks US dollar denominated broadly-syndicated, arbitrage CLOs.
ICE BofA US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market.
ICE BofA US Broad Market tracks the performance of US dollar denominated investment grade debt publicly issued in the US domestic market, including US Treasury, quasi-government, corporate, securitized and collateralized securities.
Yield to Worst measures the lowest of either yield-to-maturity or yield-to-call date on every possible call date.
The current 30-Day SEC Yield for CLOI is 6.07%.
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 adversely affect the Fund.
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.
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