Collateralized loan obligations are a specialized part of the corporate debt market that because of their relative complexity were mostly found in the realm of private investment. But a surge in the number of actively managed exchange-trade funds that deal in CLOs has brought this asset class to a larger public investing audience.
So, should CLOs have a place in your portfolio? Yes, say three investment fund managers who spoke at the recent Morningstar Investment Conference in Chicago.
“These are floating rate securities and so they still fit given the narrative from the Fed even with interest rates going down. And they trade incredibly cheap relative to (other) corporate debt,” said Jessica Shill, who manages two Janus Henderson CLO funds.
There are four main reasons everyday investors can benefit from the addition of CLOs into their portfolios:
1. Innovative asset class
CLOs are securitized debt instruments carved out of the $1 trillion universe of what is know as bank loans or leveraged debt. Although they are created from mostly high-yield debt instruments, CLOs are carved out of the various levels of risk within that broader category of bank loans, said Edwin Wilches, a managing director and co-head of PGIM Fixed Income’s securitized products.
That offers investors a wider array of opportunity than they could get from straight bank loan or senior loan funds, said Bryan Whalen, chief investment officer at TCW. And while they are not money market funds, CLOs can complement your money fund investments, he said, while enhancing yield. (A money market fund might yield 4% today while an AAA CLO fund can have a 5.5% to 6% dividend.)
2. Safety
The highest rated CLOs, the AAAs, offer the lowest returns and the least risk, All three fund managers aid they have never heard of a AAA-rated CLO default. Even among the BBB and lower rated CLOs the default rate is near zero. “CLOs are at the top of the capital structure,” Whalen said.
3. Liquidity
While CLO market can be difficult to navigate for institutional investors trying to create securitized instruments or for fund managers trying to put together a CLO ETF, for investors who buy and sell those ETFs the market is extremely liquid. The Janus Henderson Aaa CLO ETF JAAA trades millions of shares a day and its BBB cousin JBBB averages more than half a million a day.
4. Interest rate risk
The floating rate nature of CLOs give them a very low duration, which is a measure of interest rate risks. On average the CLO funds have about a 3 month duration. While that is a bigger help in times of rising rates, when investors will see their payouts rise, it can also help in falling-rate environments by limiting volatility.
In either case, the low duration can help a portfolio by diversifying it away from longer-dated credit, Shill said. “It’s always a good idea to keep some high-quality floating rate investments in your portfolio,” she said.
CLOs and ETFs
Not surprisingly, all three fund managers recommend investors who want to add CLOs to their portfolios utilize ETFs for that purpose. “ETFs get you exposure to the asset class and effectively outsource all the underwriting to the manager,” Whalen said.
Among other reasons Shill cited:
- The fees are lower
- The funds have more transparency
- ETFs are more liquid
- The ETFs are allowed in-kind redemptions, easing any pressures to sell assets at inopportune times
Because of the complex nature of CLOs, active management for any fund you pick is a must, the three managers agreed.
“This is not a set it and forget it investment,” Whalen said. “The instruments and terms are constantly changing. We’re now incorporating AI to look through all these documents to help us keep up.”
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