Collateralized loan obligations (CLOs) are often thought of as territory reserved for institutional investors, but leave it to the ever innovative exchange traded funds industry to make CLOs approachable for the masses.
Thanks to the VanEck CLO ETF (CLOI), which debuted last week, advisors have another avenue for discussing CLOs with income-hungry clients. Appropriately, CLIO is actively managed, which is an important trait because this is not the ideal asset class for indexing. It is, however, conducive to active management.
Active management is particularly important with CLOs because this a complex asset class that pools loans and other products. Add to that, CLOs are usually comprised of non-government, meaning there is an element of credit risk where active management can be advantageous in terms of damping.
Admittedly, CLIO’s status as a brand new ETF will keep it off advisor clearing platforms for the time being, but it already has $25 million in assets under management, indicating it should become available to advisors sooner than later.
Getting past its status as a rookie ETF, CLIO is undoubtedly relevant in the current environment because CLOs offer the coveted combination of rising rates protection and solid levels of income.
“In addition to higher yields and stronger risk profiles, 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. In a rising rate environment, such as the one we are in currently, CLO investors may actually benefit from higher coupons,” says William Sokol, VanEck senior product manager.
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).
Due in part to the floating rate component, CLOs beat FRNs, investment-grade corporate bonds and Treasuries in each of the prior five rising rate environments. Additionally, default risk is historically low with CLOs, providing another element of safety for clients.
“Through both the Global Financial Crisis and COVID-19 drawdown, the asset class ultimately experienced far fewer defaults than corporate bonds of the same rating. For example, of the approximately $500B of U.S. CLOs issued from 1994-2009 and rated by S&P, only 0.88% experienced defaults,” adds Sokol.
Active Advantages with CLIO
As noted above, CLIO is actively managed and that’s a positive for advisors and clients alike because CLOs are an asset class requiring a lot of homework.
“An experienced CLO tranche portfolio manager must perform rigorous due diligence on CLO managers to understand their capabilities and style, and tier them accordingly,” concludes Sokol. “However, the analysis does not end there. Each CLO is unique, even those managed by the same CLO manager. CLO tranche portfolio managers must understand the loan collateral and structural features that drive ultimate returns. This involves cashflow modelling and access to underlying CLO portfolio information, as well as real time pricing information to identify potential value.”
Some advisors are likely to let CLIO marinate simply because it’s a new product, but the reality is advisors have a new tool for offering clients interest rate protection and income. What’s not to like about that?