Call on CLOs for Lower Risk Income

It’s not a stretch to say many clients aren’t familiar with collateralized loan obligations (CLOs). Same goes for a lot of advisors out there.

There’s no shame in that because CLOs were long viewed as the territory of sophisticated professional investors, but the asset class has been democratized and none too soon because CLOs are prime territory for advisors looking to source above-average income with favorable risk profiles for clients. CLOs also offer clients some protection against rising interest rates – a point to ponder at a time when two- and 10-year yields remained elevated.

Fortunately, the list of fixed income segments that can be durable when rates rise is surprisingly robust. It's often a matter of looking beyond the most prosaic areas of the bond market and embracing some concepts that some clients may not be familiar with. That includes floating rate notes (FRNs).

When considering that economic data doesn’t imply a recession is near and that the Consumer Price Index (CPI) remains elevated, it’s not unreasonable to see the Federal Reserve continuing to hike rates over the course this year. That could highlight the near-term viability of CLOs.

Good Time to Consider CLOs

As advisors know, attempting to time when particular asset classes will be in and out of favor is a fool’s errand, but sometimes, assets tell market participants they’re ready for prime time. That could be the case with CLOs today.

“CLOs are securitized, actively managed portfolios of leveraged loans. They have historically offered a compelling combination of both an attractive yield and strong risk profiles. The strong historical performance of the asset class is a testament to the built-in risk protections resulting from how CLOs are structured,” notes VanEck’s William Sokol. “In addition, CLOs are floating rate instruments, which means their coupons reset each quarter along with prevailing interest rates, resulting in low price sensitivity to changes in interest rates. This has led to CLOs historically outperforming in periods of rising rates, like the environment we are in today.”

CLOs are attractive and unique because they feature above-average levels of income with sturdy credit quality – a combination that’s often difficult to find in the bond market.

“The structure of CLOs also helps mitigate risk. For example, coverage tests are a vital mechanism to detect and correct collateral deterioration, which directly affects the allocation of cash flows. All CLOs have covenants that require the manager to test the portfolio’s ability to cover its interest payments monthly,” adds Sokol. “If the tests come up short, cash flows are diverted from more junior tranches to pay off the most senior tranches first, until these failures are cured.”

CLOs Compelling Alternatives to Corporate Debt

One of the most traditional approaches to sourcing higher income bonds is to embrace corporate debt, both investment-grade and junk. However, those fixed income segments could be vulnerable in the event a recession comes to pass.

If that happens, default rates – already inching higher –- could spike, but that’s not a major concern with CLOs.

“Over the long term, CLO tranches have offered higher yields and historically performed well relative to other corporate debt categories, including leveraged loans, high yield bonds, and investment grade bonds, and have significantly outperformed at lower rating tiers. The built-in risk protections of CLOs have resulted in a track record of strong risk-adjusted returns versus other fixed income asset classes, particularly for investment grade-rated CLO tranches,” concludes Sokol.

Related: 3 Areas of Emphasis for Advisors Working With Female Clients