Structural Protections of CLOs
August 09, 2024
Watch Time 4:27 MIN
CLOs benefit from multiple structural protections, including active management, credit support, covenants and collateral requirements.
Structural Protections of CLOs
In addition to the strength of the underlying collateral, CLOs benefit from other protections that help to reduce risk.
So first, these are actively managed portfolios. So you have a credit manager who's building the portfolio, reinvesting cash flows, and is able to avoid issuers or sectors that perhaps they don't like. And this goes a long way in terms of maintaining the overall quality of the portfolio.
Second, you have the equity tranche This is the first loss tranche that will absorb losses in the portfolio before any of the CLO debt holders. This is the riskiest tranche of a CLO, but it also has the highest return, because equity investors earn the excess cash flows after payment of interest to the CLO debt. But this excess cash flow is also there to make up any shortfalls that may exist to make sure that the senior note holders get paid.
Third, you have a variety of covenants and collateral tests that need to be satisfied, both to achieve and maintain credit ratings on the tranches, but these also impact the priority of cash flows. So for example, if interest coverage or over-collateralization tests of a CLO are not satisfied, the manager will work to bring the portfolio into alignment with these guidelines. But until that happens, cash flows are diverted from the junior tranches up to the more senior tranches.
So overall, CLOs are structured to protect those senior debt holders, especially in cases where there's deterioration in the loan portfolio, in order to make sure that they get paid first.
Performance and Stability
From a default perspective, CLOs have performed very well with extremely low default rates over the last 20 years, default rates which are lower than corporate bonds. In fact, no AAA or AA tranches ever defaulted. This is reflective of the structural protections that you get with CLOs. And this high quality, as well as the higher yields that you get with CLOs, has resulted in returns that have been very good over the last decade.
In fact, CLOs are the best performing fixed income asset class over the last 10 years from a risk adjusted standpoint. Because of the way that CLOs are structured, you have the ability to tailor the risk and return depending on what your objectives are. So for example, investing in lower rated mezzanine tranches gives you the potential for much higher yields and greater return potential. On the other hand, AAAs and AAs provide safety and stability while also providing a yield pickup versus similarly rated corporates.
We think the best opportunities come from being able to invest throughout the CLO capital structure. This allows for potentially higher yields and total return opportunities by being able to adjust the portfolio as market conditions or the rate environment changes. We think this can provide better outcomes versus a ratings constrained approach without having to take excessive risks.
Overall, investment-grade CLOs provide a very compelling combination of high quality as well as higher yield. And we believe they deserve a strategic allocation within a core bond portfolio.
But this is a unique market, and we think investors are best served by investing with an experienced manager who takes an active approach. So this is both in terms of how they construct the portfolio—for example, the types of rating exposures they have given market conditions, but also the due diligence that they're able to do on each individual CLO. Every CLO is different in terms of the underlying portfolio, the CLO manager style, and every deal can have unique terms. You can't just look at the ratings. You need to do due diligence on every single investment that's made.
CLOI | VanEck CLO ETF
This is why on the VanEck CLO ETF, we partnered with PineBridge Investments, because they've been in this market for decades. They've been managing CLO tranche strategies for their institutional clients for many years. And now all types of investors have access to these capabilities as well as the opportunities that investment-grade CLOs can provide through CLOI.
IMPORTANT DISCLOSURE
Index descriptions:
J.P. Morgan CLO Index is comprised of U.S. dollar denominated arbitrage CLOs of broadly syndicated loans.
J.P. Morgan CLO AAA Index is a subset of the J.P. Morgan CLO Index that only tracks the AAA rated CLO.
J.P. Morgan CLO AA Index is a subset of the J.P. Morgan CLO Index that only tracks the AA rated CLO.
J.P. Morgan CLO A Index is a subset of the J.P. Morgan CLO Index that only tracks the A rated CLO.
J.P. Morgan CLO BBB Index is a subset of the J.P. Morgan CLO Index that only tracks the BB rated CLO.
J.P. Morgan CLO BB Index is a subset of the J.P. Morgan CLO Index that only tracks the BB rated CLO.
ICE BofA US Corporate Index (C0A0) tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market.
ICE BofA US High Yield Index (H0A0) tracks the performance of U.S. dollar-denominated below investment grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a below investment grade rating. Original issue zero coupon bonds, 144a securities, both with and without registration rights, and pay-in-kind securities, including toggle notes, qualify for inclusion. Eurodollar bonds, taxable and tax-exempt U.S. municipal, warrant-bearing, DRD-eligible and defaulted securities are excluded from the Index.
ICE BofA US Broad Market (US00) 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.
MVIS US Investment Grade Floating Rate Index consists of U.S. dollar denominated floating rate notes issued by corporate issuers and rated investment grade.
Morningstar LSTA US Leveraged Loan 100 Index seeks to mirror the market-weighted performance of the largest institutional leveraged loans as determined by criteria based upon market weightings, spreads, and interest payments.
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 author(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, foreign currency, foreign securities, investment focus, newly-issued securities, extended settlement, affiliated fund investment, management and capital preservation, derivatives, currency management strategies, 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 a Fund 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.
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