Looking to Enhance Your Credit Portfolio? See How CLOs May Fit.

June 19 2023

Why have credit investors been increasing their allocations to Collateralized Loan Obligations (CLOs)?

Credit-related investments are a $13+ trillion component of the global fixed-income markets, according to PIMCO. Investors pursue credit investing for 3 potential benefits:

  • Higher yields
  • Diversification
  • Enhanced total returns

How does the CLO asset class potentially provide these benefits?

Spectrum of Credit Opportunities

Credit represents a broad spectrum of investments in both public and private markets. Public markets include the direct obligations of borrowers, such as corporate bonds and loans. The private markets include direct loans to smaller middle market companies, and includes structured or securitized assets (like CLO equity and mezzanine) offering a share of interest and principal payments from an underlying loan portfolios. Each type of credit investment, whether public or private, comes with its own particular risk/return profile.

At their core, CLOs are credit investments. CLOs are collateralized by an underlying portfolio of senior, secured, floating-rate leveraged loans to large and middle-market corporations.

Where Do CLOs Fit?

Where do CLOs fit in a broader credit and fixed-income portfolio?

To understand where CLOs fit, one must understand the credit universe, which is divided into public and private markets. Public markets represent the largest and most visible part of the credit universe:

Public credit markets

CLOs can be categorized as both public and private market investments. Higher-rated CLOs are part of the public credit markets (above), while lower-rated and equity CLO tranches are considered to be part of the private markets:

Private credit markets

CLOs have historically exhibited higher yields and strong relative value compared to comparably rated fixed-income and credit investments—the foundation of their appeal. As a result, CLOs are able to provide the three potential benefits of credit investing: (1) higher yields, (2) diversification, and (3) enhanced total returns.

(1) Higher Yields

CLOs have the potential to provide high income. For investors seeking higher yields than traditional fixed income, CLOs may be an attractive option. As illustrated below, CLOs offer improved spreads relative to comparably rated bonds and loans across the rating scale:

Favorable CLO spreads compared to other credit sectors

(2) Diversification

Another use of CLOs in a credit portfolio is for diversification. CLO collateral portfolios generally include hundreds of corporations across dozens of industries. By adding CLOs to a portfolio of credit assets, investors can potentially reduce their exposure to any one particular credit sector or issuer. This can help mitigate risk and potentially improve overall portfolio performance.

(3) Total Returns

Opportunistic investors allocate to certain CLO tranches in pursuit of higher total returns. Such investors will focus on junior mezzanine and equity tranches for the highest yields within the asset class, and will opportunistically trade securities in pursuit of price appreciation, particularly during periods of market dislocation. CLO tranches have earned higher total returns over time relative to most comparably rated bonds or loans:

US CLO Returns Versus IG Credit, High Yield, and Leveraged Loans

CLO Capital Structure and Investor Preferences

CLOs fit a wide range of investor risk preferences. CLOs are issued in tranches with ratings from S&P, Moody’s, or Fitch, the major rating agencies. The ratings reflect the rank of a CLO tranche in the priority of claims on interest and principal payments from underlying loans:

CLO Tranches, Ratings, and Credit Quality

The CLO capital structure includes tranches rated investment grade (AAA, AA, A); senior mezzanine (BBB); and junior mezzanine (BB, B). Unrated CLO equity represents the base of the capital stack, typically about 10% of the capitalization of a CLO. The equity tranche receives the interest remaining after payments to other tranches.

How Investors Use Senior, Investment Grade CLO Tranches

Senior, investment-grade tranches are popular with banks in the U.S. and abroad, insurance companies, pension funds, and institutions seeking higher yields than comparably rated bonds. The higher yields and greater spreads result from perceived complexity of CLO structures. CLO investment grade tranches are liquid securities that have an active trading market and generally settle within two business days.

AAA CLOs are the largest tranche of the CLO market, representing over 60% of the CLO capital stack. AAA CLOs are popular with more conservative investors.

How Investors Use Senior and Junior Mezzanine CLO Tranches

CLO mezzanine securities offer a variety of return profiles.

Some investors invest in senior mezzanine tranches (BBB) for higher yields while maintaining an investment grade rating. Junior mezzanine tranches (BB—or B which are not always issued) appeal to investors with a higher risk appetite that seek high levels of income.

Senior Mezzanine

Senior Mezzanine (BBBs) CLOs are utilized by investors seeking higher yields, but who still prefer investment grade securities. BBB CLOs may be preferable for traditional fixed-income portfolios due to their rating and seniority to junior mezzanine and equity tranches. In fact, BBB CLOs recently became available via ETFs. 

Junior Mezzanine

Junior Mezzanine CLOs (BB or B) with higher spreads may be used to enhance a portfolio with higher yields or increase diversification of a multi-asset class credit portfolio. Opportunistic credit portfolios, such as hedge funds and private credit funds will also invest across junior mezzanine CLO tranches.

Some investors will pursue and trade junior mezzanine tranches amidst market dislocations that often accompany higher price volatility. In the past, some hedge funds have been compelled to sell mezzanine holdings during market setbacks to meet investor redemptions, creating bargain entry points for others. The periodic volatility of junior mezzanine tranches can create profit opportunities for nimble CLO market participants.

How Investors Use CLO Equity Tranches

CLO equity is a CUSIP security with a standard two-day settlement period for secondary market purchases. New issue CLO equity has a settlement period ranging from 3 to 6 weeks from a deal’s pricing date. CLO equity has a “high octane” return profile, even in a normalized market, and there are opportunities for enhanced returns in times of market volatility. Due to the level of specialization needed to analyze CLO equity, this particular asset class may be a better fit for dedicated CLO equity portfolios or specialized CLO mandates.

Investors will tap CLO equity for varied portfolio applications:

  • Potential double-digit current yields
  • As an opportunistic component within a broader credit allocation
  • a complement to a traditional private credit or direct lending portfolio
  • a “J-curve” mitigant against a private equity portfolio

CLO equity valuations can move in tandem with the equity markets and may exhibit similar market volatility. However, the underlying risks for CLO equity securities are senior secured loans to large corporations. Thus, CLO equity may be more insulated to market volatility than through direct investments in the public equity markets. Quarterly income payments to CLO equity holders, which are significantly higher than traditional listed equity dividends, also serve to help stabilize returns and mitigate the volatility of CLO equity.

Mind the Risks

CLOs present a variety of opportunities and applications for credit-oriented investors.

However, it's worth noting that CLOs carry a variety of risks, such as credit risk, market risk, illiquidity risk, prepayment risk, and manager risk, among others.

As with any investment, it’s important for investors to carefully consider these risks before investing. It’s also important to work with a specialist who can help you navigate the CLO markets and develop an allocation that fits your objectives and risk-return profile.

Next Steps

Are you exploring CLO investment opportunities?

To learn more, read our FREE ebook:

13 Powerful Benefits of CLOs for Today’s Income Investor (and 7 Risks to Know)

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