Collateralized loan obligations, or CLOs, may be a way for advisors to enhance retail clients’ portfolios.
They provide investors with access to a diverse pool of senior secured loans. While they have been primarily used by institutional clients to date, CLOs could enhance risk-adjusted returns for individual clients.
CLOs are securities backed by a pool of debt, usually loans to well-known corporations such as Hilton, United, and Restoration Hardware, said Danielle Gilbert, managing director for business development at Panagram Structured Asset Management, during VettaFi’s Alternatives Symposium on November 28.
Bill Sokol, director of ETF product management at VanEck, said CLOs are higher-yield, higher-spread products compared to traditional corporate bonds. Plus, CLOs don’t come with duration risk.
“That has obviously been very attractive the last few years,” he added. “CLOs [are]outperforming investment grade by about 600 basis points year to date, and a similar story in 2022 to a much greater degree.”
Under the Hood of CLOs
Each CLO comprises 150 to 300 loans. Importantly, these loans are secured. They sit at the top of the corporate capital structure, giving investors a claim on the assets of the company, according to Gilbert.
The value of where you are within the capital structure for CLO determines prioritization of those cash flows. “There are CLO bonds that are rated AAA, AA, A, all the way down to BB,” he explained. “The senior priority obviously goes to the AAA. In the current market, the yield for AAAs is around 6-7%.”
Even at the BB part of the capital structure, investors have security and cushion. CLOs just don’t have the same amount of default risk as corporate bonds due to their structure, Sokol said.
He added that the default rate for CLOs has been very close to zero in most years. There have been small blips here and there, particularly after the financial crisis. However, even then, it was nothing like what was seen in corporate bonds, especially as high yield bonds had default rates of 10%, he noted.
“You’re not taking first loss on any of that diverse pool when there is a default because that’s the way that the CLO is structured,” Gilbert said.
CLOs as an asset class have over $1 trillion in assets, most of which has been institutional money. “But we love it also for the individual because it’s the best risk-adjusted exposure to U.S. corporate credit,” Gilbert added.
