Fixed income investors who want to diversify their portfolios in a challenging market environment shouldn't overlook CLOs. Danielle Gilbert, managing director at Eldridge Capital Management, discussed the value of CLOs in investment portfolios with VettaFi’s Todd Rosenbluth in the recent Income Investment Strategy Symposium.
Collateralized loan obligations (CLOs) are securitized portfolios comprised of a collection of company loans, mostly leveraged. They’re generally made up of senior secured loans, which receive first priority in the event of bankruptcy and make an attractive alternative to corporate bonds. As borrowers repay the loans within the fund, CLO investors earn returns on the cash flow generated. While investors often conflate them with CDOs (collateralized debt obligations), Gilbert notes the two offer “vastly different exposures.” CLOs also eliminate single concentration risk, because anywhere from 150–300 companies on average back each fund.
“With CLOs… the loans are to companies that you’ve heard of,” such as Chobani Yogurt, Jane Street, and Tory Burch, explained Gilbert. “These are names you’re going to be familiar with, but the exposure is small… and the pools are actively managed by credit managers.”
The Surprising Truth About Default Risk in CLOs
CLOs are broken down into several different debt tranches, with each tranche carrying its own risk and return profile. The tranches have their own loss risks, priority for cash flow distributions, and credit quality. The top tranche is comprised of CLO bonds rated AAA, with debt tranches tiered all the way down to unrated equity loans. Investors can choose what type of credit exposure aligns with their desired risk profile, with minimal interest rate risk.
“The fact that that these are floating rate — you don’t have to worry about what the Fed is doing because you have the benefit of not having that interest rate duration risk,” Gilbert said. “We think it’s the best way to get the best risk-adjusted exposure versus direct loan exposure.”
Investors leery of CLOs because of the collapse of CDOs during the Great Financial Crisis may want to reconsider the class. A number of structural changes post-GFC create a very different risk profile than the pre-GFC counterparts. These include general standardization and also additional cushions against loss at each rating tier, Gilbert noted.
Within BB rated CLOs, default rates sat around 4% pre-GFC. In the wake of the GFC and changes, there have only been 10 CLO BB defaults. Between AAA and BBB, CLOs experienced zero defaults post-GFC. Over a similar 13-year time period, an equivalent BB rated corporate loan experienced defaults of approximately 15%.
Since the inception of the CLO market (dating back to 1996), a AAA rated CLO has never defaulted. “These are incredibly resilient structures, and often misunderstood,” explained Gilbert.
Where to Fit CLO Strategies Into Your Fixed Income Portfolio
CLOs make strong compliments to portfolios in general, across any market environment, because investors can choose their risk exposure. The added bonus of no duration risks (CLO contracts reset on a quarterly basis) make them particularly appealing. The inherent diversification of the loans also warrants consideration in a challenging market year. “You’re not taking any single concentration bets on a specific industry or a specific name,” Gilbert said. “They’re actively managed pools by credit managers… and you’re taking that exposure and putting it into a structure where there’s a buffer on losses.”
CLO strategies also make strong additions to a fixed income portfolio specifically. At the top end, the AAA rated CLO funds can sit comfortably alongside a number of strategies in an income portfolio. The higher yield and lower-rated CLO funds can potentially replace or complement corporate high yield funds. They may even replace loan ETFs. Advisors and investors can even rotate different CLO strategies into and out of their portfolio as their credit views change.
Eldridge offers two CLO ETFs for investors, the Eldridge AAA CLO ETF (CLOX) and the Eldridge BBB-B CLO ETF (CLOZ).
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