How CLOs Can Provide an Alternative to Traditional Bond ETFs

Fixed income ETF demand has been strong in 2023 led by Treasury ETFs. However, advisors have been rewarded by turning to alternatives in the fixed income space, such as those focused on the collateralized loan obligations (CLOs) market.

What Are CLOs?

According to asset manager VanEck, a CLO is a portfolio of predominantly senior secured loans that is securitized and actively managed. Senior secured loans receive the highest priority in the event of bankruptcy, and leveraged loans have demonstrated strong creditworthiness. The trailing 12-month default rate within the Morningstar US Leveraged Loan Index was 1.27% in September.

Each CLO issues a series of floating rate bonds, along with a first-loss equity tranche. The tranches differ in terms of subordination and priority — thus, lowest to highest in order of riskiness. Cash flows from the underlying loans of a CLO are used to pay interest on the debt tranches. They get distributed based on a waterfall. Cash flows are paid sequentially, starting with the senior-most tranche until each tranche has been paid its full distribution. Equity-tranche holders receive the residual distributions, net of costs. Principal distributions are similarly applied first to the most senior tranches

CLOs have historically offered a compelling combination of an attractive yield and strong risk profiles. 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.

Growing Supply of CLO ETFs

The Janus Henderson AAA CLO ETF (JAAA) is the largest of the CLO-focused ETFs. JAAA launched in October 2020 and now has $4.7 billion in assets. However, there have been newer entrants worthy of attention.

The VanEck CLO ETF (CLOI) launched in June 2022 and has over $200 million in assets. CLOI and JAAA rose 8.0% and 7.2% year to date through November 16, respectively. This compares favorably to the 4.3% gain for the SPDR Bloomberg 1-3 Month T-Bill ETF (BIL). Meanwhile, advisors that took on credit risk through corporate bond ETFs have also missed out. The Vanguard Intermediate Term Corporate Bond (VCIT) and the iShares iBoxx $ High Yield Bond ETF (HYG) had total respective returns of 3.0% and 6.5%.