CLOs: Benefits and Risks
Collateralized loan obligations (CLOs) are attracting increasing attention as investors broaden their horizons in the search for yield. While many investors know that CLOs have historically yielded attractive performance versus other fixed income strategies, they may not know the full extent of the benefits – as well as the distinct risks.
With CLOs, investors may benefit from the following:
Attractive performance. Over the long term, CLO tranches have performed well relative to other corporate debt categories, including bank loans, high yield bonds, and investment grade bonds, and have significantly outperformed at lower rating tiers.1
Wider yield spreads. CLO spreads have typically been wider than those of other debt instruments, reflecting CLOs’ greater complexity, lower liquidity, and regulatory requirements. Compared with investment grade corporates, as well as other higher-yielding debt sectors – notably high yield and bank loans – CLO spreads are especially compelling.
CLO Spreads Are Compelling Versus Other Debt Sectors
CLO spreads versus comparably rated corporate bonds
Source: JP Morgan, Bloomberg, and S&P/LCD as of 31 August 2021. US CLO debt represented by the JP Morgan CLOIE Index; IG credit: Bloomberg US Credit Index; High yield bonds: Bloomberg US Corporate High Yield Bond Index; Leveraged loans: S&P/LSTA Leveraged Loan Index.
Low interest-rate sensitivity. Leveraged loans and their CLO tranches are floating-rate instruments, priced at a spread above a benchmark rate (such as Libor,2 Euribor, and SOFR). As interest rates rise or fall, CLO yields will move accordingly, and their prices have historically moved less than those of fixed-rate instruments. These characteristics can be advantageous to investors in diversified fixed income portfolios.
An attractive risk profile. As demonstrated by a variety of key metrics, with impairment rates the most notable example, CLOs have historically presented lower levels of principal loss when compared with corporate debt and other securitized products.3
Lower default rates. Of the approximately $500 billion of US CLOs issued from 1994-2009 and rated by S&P (vintage 1.0 CLOs), only 0.88% experienced defaults, and an even smaller percentage of those, 0.35%, were originally rated BBB or higher (see table below). If we consider those deals rated by Moody’s, there have been zero defaults on the AAA and AA CLO tranches across all vintages (1.0 through 3.0).
Even Vintage 1.0 CLOs Experienced Minimal Defaults
Source: S&P Global Ratings as of 2 August 2018.
Diversification. CLO correlations versus other fixed income categories have been relatively low, meaning that many CLOs have historically increased the effective diversification of a broader portfolio.4
Inflation hedge. CLOs’ floating-rate yields have historically made them an effective hedge against inflation.
Strong credit quality. Unlike most corporate bonds, leveraged loans are typically both secured and backed by first-lien collateral.
While there are many benefits, CLOs are complicated investments. Naturally, they also present a number of risks that investors should consider carefully. These include:
Credit risk. While CLOs have historically enjoyed strong credit quality due to the senior secured status of leveraged loans, it’s important to keep in mind that leveraged loans carry inherent credit risk: They’re issued to below-investment-grade companies whose revenue streams are sensitive to fluctuations in the economic cycle.
The potential for collateral deterioration. If a CLO’s loans experience losses, cash flows are allocated to tranches in order of seniority. Depending on the severity of the losses, the value of the equity tranche could be wiped out and junior loan tranches could lose principal.
Non-recourse and not guaranteed. Leveraged loans are senior obligations and, as such, generally have full recourse to the borrower and its assets in the event of default. A CLO, however, has recourse only to the principal and interest payments of the loans in the portfolio.
Loan prepayments. Leveraged loan borrowers may choose to prepay their loans in pieces or completely. While experienced CLO managers may anticipate prepayments, they’re nonetheless unpredictable. The size, timing, and frequency of prepayments could potentially disrupt cash flows and challenge managers’ ability to maximize portfolio value.
The potential for trading illiquidity. CLOs generally enjoy healthy trading liquidity, but that could change very quickly if market conditions turn. A prime example is the financial crisis, when trading activity for even the most liquid debt instruments slowed to a trickle.
The timing of issuance. While market conditions could be strong when a CLO is issued, they might not be during its reinvestment period. That’s what happened to the 2003 vintages, whose reinvestment period coincided with the onset of the financial crisis and its resulting drop-off in trading volume.
Manager performance. Historical performance of CLO managers encompasses a wide spectrum of returns, underscoring the importance of choosing seasoned managers with solid long-term track records.
Spread duration. While interest rate duration is low due to the floating-rate nature of CLO tranches (indexed off three-month Libor,5 Euribor, or SOFR), spread duration is a consideration that should be taken into account. Due to a typical reinvestment period of four to five years, spread duration is usually between 3.5 and seven years. The higher up the capital stack, the lower the spread duration, as each CLO is redeemed sequentially, making the lower-rated tranches longer in spread duration.
To learn more about CLOs, read our full CLO primer, “Seeing Beyond the Complexity: An Introduction to Collateralized Loan Obligations.”
1 9.5-year annualized returns as of 30 June 2021. Sources: JP Morgan, Bloomberg, and S&P/LCD. US CLO debt represented by the JP Morgan CLOIE Index; IG credit: Bloomberg US Credit Index; High yield bonds: Bloomberg US Corporate High Yield Bond Index; Leveraged loans: S&P/LSTA Leveraged Loan Index.
2 Libor references should be considered illustrative, as this rate is effectively ceasing by the end of 2021. Please review “Risks Related to the Discontinuance of the London Interbank Offered Rate (“Libor”)” found at the end of this presentation for more information regarding this transition.
3 As of 22 January 2021. Source: Moody’s, Barclays Research. CLO impairment and loss given default (LGD) rates by original rating and based on 10-year cumulative data over 1993-2019. Impairments split by principal (outstanding principal write-down or loss >50bp of the original tranche balance or security carrying Ca or C rating, even if not yet experienced an interest shortfall or principal write-down) and interest (outstanding interest shortfall >50bp of original tranche balance).
4 Source: JP Morgan, Bloomberg, 9.5-year correlations as of 30 June 2021. CLOs represented by the JP Morgan CLO Post-Crisis Index. US Treasury bonds represented by the Bloomberg Long Treasury Index. US aggregate represented by the Bloomberg US Aggregate Index. US IG credit represented by the Bloomberg US Credit Index. Securitized products represented by the Bloomberg US Securitized: MBS/ABS/CMBS and Covered TR Index. High yield represented by the Bloomberg US Corporate High Yield Index. EM debt represented by the JP Morgan EMBI Global Diversified Composite Index.
5 Libor references should be considered illustrative, as this rate is effectively ceasing by the end of 2021. Please review “Risks Related to the Discontinuance of the London Interbank Offered Rate (“Libor”)” found at the end of this presentation for more information regarding this transition.
Investing involves risk, including possible loss of principal. The information presented herein is for illustrative purposes only and should not be considered reflective of any particular security, strategy, or investment product. It represents a general assessment of the markets at a specific time and is not a guarantee of future performance results or market movement. This material does not constitute investment, financial, legal, tax, or other advice; investment research or a product of any research department; an offer to sell, or the solicitation of an offer to purchase any security or interest in a fund; or a recommendation for any investment product or strategy. PineBridge Investments is not soliciting or recommending any action based on information in this document. Any opinions, projections, or forward-looking statements expressed herein are solely those of the author, may differ from the views or opinions expressed by other areas of PineBridge Investments, and are only for general informational purposes as of the date indicated. Views may be based on third-party data that has not been independently verified. PineBridge Investments does not approve of or endorse any republication of this material. You are solely responsible for deciding whether any investment product or strategy is appropriate for you based upon your investment goals, financial situation and tolerance for risk.
Risks Related to the Discontinuance of the London Interbank Offered Rate (“Libor”)
Libor an estimate of the rate at which a sub-set of banks (known as the panel banks) could borrow money on an uncollateralized basis from other banks. The United Kingdom (the “UK”)’s Financial Conduct Authority (the “FCA”), which regulates Libor, has announced that it will not compel banks to contribute to Libor after 2021; the panel banks will still be required to submit the USD 1-month, 3-month, 6-month and 12-month Libor settings until 30 June 2023. As that date approaches the FCA could decide to require the continued publication of these settings on a synthetic basis, which would represent an approximation of each setting, in order to reduce disruption in the market. On 3 April 2018, the New York Federal Reserve Bank began publishing its alternative rate, the Secured Overnight Financing Rate (“SOFR”). The Bank of England followed suit on 23 April 2018 by publishing its proposed alternative rate, the Sterling Overnight Index Average (“SONIA”). Each of SOFR and SONIA significantly differ from Libor, both in the actual rate and how it is calculated, and therefore it is unclear whether and when markets will adopt either of these rates as a widely accepted replacement for Libor. If no widely accepted conventions develop, it is uncertain what effect broadly divergent interest rate calculation methodologies in the markets will have on the price and liquidity of loans and debt obligations held by the funds, securities issued by the funds and our ability to effectively mitigate interest rate risks.
The Alternative Reference Rate Committee confirmed that the 5 March 2021 announcements by the ICE Benchmark Administration Limited and the FCA on the future cessation and loss of the representativeness of the Libor benchmark rates constitutes a “benchmark transition event” with respect to all U.S. dollar Libor settings. A “benchmark transition event” may cause, or allow for, certain contracts to replace Libor with an alternative reference rate and such replacement could have a material and adverse effect on Libor-linked financial instruments.
As of the date of this presentation, no specific alternative rates have been selected in the market, although the Alternative Reference Rates Committee convened by the Board of Governors of the Federal Reserve System has made recommendations regarding a specified alternative rate based on a priority waterfall of alternative rates and certain bank regulators and the SEC are encouraging the adoption of such specified alternative rate. It is uncertain whether or for how long Libor will continue to be viewed as an acceptable market benchmark, what rate or rates could become accepted alternatives to Libor, or what the effect any such changes could have on the financial markets for Libor-linked financial instruments. Similar statements have been made by regulators with respect to the other Inter-Bank Offered Rates (“IBORs”). Certain products / strategies can undertake transactions in instruments that are valued using Libor or other IBOR rates or enter into contracts which determine payment obligations by reference to Libor or one of the other IBORs. Until their discontinuance, the products / strategies could continue to invest in instruments that reference Libor or the other IBORs. In advance of 2021, regulators and market participants are working to develop successor rates and transition mechanisms to amend existing instruments and contracts to replace an IBOR with a new rate. Nonetheless, the termination of Libor and the other IBORs presents risks to product / strategies investing in Libor-linked financial instruments. It is not possible at this point to identify those risks exhaustively, but they include the risk that an acceptable transition mechanism might not be found or might not be suitable for those products / strategies (as applicable). In addition, any alternative reference rate and any pricing adjustments required in connection with the transition from Libor or another IBOR could impose costs on, or might not be suitable for applicable products / strategies, resulting in costs incurred to close out positions and enter into replacement trades.