CLOs for the Little Guy

While repackaging, chopping up, and distributing pieces of financial engineering have developed a reputation for devilish alchemy – I on the other hand find it all quite fascinating. I’ll spare you the details on the basics, as I’ve put together a repository of primers in the Resources section of this website. If you don’t understand the mechanics of CLOs, this won’t make much sense. If you’re looking for a multi-bagger or something that outperforms the S&P, close the tab and move on, it isn’t here. Last, if you’re looking for commentary from a structured credit expert, I am far from that. In this post, I’ll focus on what my personal conclusions are with respect to how a retail investor can interact with CLOs.

The CLO capital stack allows an institutional investor to target a risk / return profile with some level of precision. An investor can purchase diversified AAA debt slices with no prior defaults (never say never) or CLO equity, the most risky slice with theoretical returns in the low teens.

While some investors will scream of tax inefficiency, as the majority of the return comes in the form of ordinary income, I will ignore that relevant fact for the sake of this discussion.

But why do CLOs offer potentially higher returns for similar “risk?” Here are ideas, albeit unoriginal, but in my words.

Relative Age of Market

The CLO market is “new” versus the bond market. CLOs came to light in the 90s and accelerated as a feature of the financial system over the past 20 years:

After the financial crisis of 2008, the industry underwent a change in standardized structure and terms.

CLOs allow banks to pass on (and collect fees on) loans they originate to willing buyers that don’t have the front end infrastructure to originate loans themselves. It allows banks to earn higher returns on their equity versus being weighed down by the capital drag of originated loans, especially in light of post-financial crisis regulation that increased capital requirements for riskier holdings. Here’s an overview of the CLO buyer pool:

Retail investors are material participants in the market underpinning CLOs, leveraged loans. They participate via publicly traded BDCs, floating rate loan funds, private BDCs / interval funds, and more. Below is an overview of leveraged loan ownership in the US and EU, with retail clocking in at between 15-20% in the US:

However, retail participation in the CLO market, especially CLO debt tranches, is certainly far lower than leveraged loan participation. Only recently have ETF structures that allow access to CLO debt appeared and are currently minuscule in size. It remains to be seen whether retail interest in CLOs will increase over time.

It Rhymes with CDOs

Three letter acronyms of financial engineering were foundational components of the ’08 credit crisis. But there are important distinctions between today’s CLOs and CDOs of the 2000s.

CLOs are backed by simpler, more diversified pools of collateral than CDOs. CDOs issued in the run-up to the GFC consisted mainly of subprime MBS, and CDOs backed by other CDOs (so called CDO squared) were common.

In 2006, almost 70% of the collateral of newly issued CDOs corresponded to subprime MBS, and a further 15% was backed by other CDOs. Furthermore, more than 40% of the collateral gathered by the CDOs issued that year was not cash MBS, but CDS written on such securities. When conditions in the housing market turned, the complexity and opacity of CDOs amplified financial stress. Their collateral is diversified across firms and sectors, and the known incidence of synthetic collateral or resecuritisations is minimal.

BIS.org

And one can see the dramatically lower credit enhancement when legacy subprime MBS CDOs and CLOs are compared side by side:

While it sounds somewhat silly to think that institutional investors may shun CLOs do to a misplaced association, I believe that the perceived complexity and similarities to the CDO trash fire of the past make this asset class the opposite of something in which the old adage “can’t get fired for buying X” applies.

Volatility is High

Once you look lower than the A tranche of the CLO structure, you find that the BBB and BB debt tranches have relatively elevated standard deviation.

Asset	Return %	Std. Dev %
S&P 500 (’01-today)	10	15
CLO Equity	11-14*	20+*
BB CLO	9	16
BBB CLO	7	10

One can presume that CLO equity is step-wise more volatile than the BB tranches, likely far exceeding S&P500 volatility. Excess volatility demands excess return, and thus it makes sense that BB and lower rated tranches may offer higher returns with “higher risk.” Why that elevated return spills over into BBB and higher rated debt which doesn’t appear to have the same level of elevated standard deviation, I’m not exactly sure, and may attributable in entirety to the prior factors I outlined.

The Little Guy

While assessing whether CLOs fit your own investment goals is your own responsibility, I will outline what my own opinion is of the various publicly traded retail CLO offerings that exist on today’s marketplace.

Until only a few years ago, there were no options to invest in the debt tranches of CLOs via an ETF wrapper. One could access debt tranches via publicly traded closed end funds (CEFs), but their equity-like fee structures and leverage appear to be a mismatch for the underlying assets.

Recently, Janus Henderson and Van Eck both came to market with their own ETF offerings focused on CLO debt. Between the three ETFs, investors can effectively access the AAA tranche, the AA tranche, and the BBB tranche – at fee rates far lower than the CEF structures.

	JAAA	CLOI	JBBB
Fund Size	$1.6B	$25M	$80M
AAA	96%	29%	–
AA	3%	47%	–
A	1%	9%	–
BBB	–	–	90%
BB	–	–	7%
B	–	–	3%
Not Rated	–	15%	–
# of Holdings	114	18	66
Fee rate	0.26%	0.4%	0.5%

Through these ETFs, an investor can attain reasonable CLO manager and vintage diversification, not to mention dramatic underlying loan diversification. However the overall fund sizes are relatively small, especially JBBB and CLOI. I would personally like to see more diversification within CLOI, as its largest holding is roughly 10% of AUM. However it is important to note that the Janus offerings’ feature documented mandates of issuer and single CLO concentration limits (15% issuer, 5% single CLO), whereas the Van Eck fund is classified as non-diversified. In fact CLOI’s largest investment is roughly 10% of the fund. Thus CLOI may be better viewed as a discretionary fund versus JAAA/JBBB being more systematic exposure to specific portions of the ratings stack.

An investor will have a harder time understanding what the yield of each fund is, especially while rates are moving so quickly. Each CLO debt tranche has a floating rate based on LIBOR / SOFR plus a spread. Today, base rates (LIBOR / SOFR) are moving rapidly with Federal Reserve action and there are limitations on the forward projections that ETF managers can provide (versus a private fund).

I downloaded the daily holdings data (self reported) of each ETF and was able to calculate the market price of the underlying CLO debt (vs par), the weighted average coupon at the time (given it is moving along with rates), and the implied current yield based on the market price.

	JAAA	CLOI	JBBB
% of Par	98.6%	97.9%	92.2%
Wtd. Avg. Coupon	3.2%	4.0%	5.6%
Gross Current Yield	3.2%	4.1%	6.1%
Net Current Yield	3.0%	3.6%	5.6%
8/31 30D SEC Yield	3.7%	4.2%	6.2%

Note in the above, there may be delays in the reporting of latest coupons adjusted for higher base rates versus reported distributions, resulting in higher reported SEC yield based on prior distributions vs calculating it off of the coupons reported in holdings downloads.

Given the discount to par in the overall market and within these funds, it is important to have a baseline view on what default rates and ultimate recovery rates will be in the leveraged loan market (along with a host of CLO specific assumptions). That may help inform whether the discounts to par represent an opportunity as loans “pull to par” or further price degradation will ensue. As this is entirely personal, I will leave that to the reader to decide.

While defaults have been low within the CLO space across most debt tranches, one has to consider that future performance is a function of the underlying collateral, not historical data. One may have more cause to worry given recent trends of ratings quality underlying leveraged loans:

It’s clear that there has been migration towards lower rated collateral with B- representing the largest share of leveraged loans, even considering the tighter credit environment in 2022. If one considers ratings reflective of future credit performance, one might expect greater frequency and severity of defaults during a credit cycle.

However the credit losses that one must incur to pierce the principal of the BBB layer, for example, is deep in the capital stack. Per the below representative CLO, the BBB layer has ~25% in credit enhancement or first loss capital above it.

CLO Debt ETF Risks

The principal risk I see in the ETF structure as it pertains to accessing CLO debt is a liquidity vacuum. Specifically, in times of stress, one can presume an ETF will see outflows of funds as retail investors retreat to cash and / or reallocate. The result is that the ETF manager has to sell a corresponding amount of assets.

While that works just fine when an ETF owns deeply liquid securities, it starts to break down when the opposite is true. The ETF manager of assets with greater illiquidity than say, large cap equity ETFs, will often have to sell the most liquid assets first as there may not be a bid for the least liquid assets. Selling one’s most liquid assets leaves an ETF in a shaky position, and not one that the resulting ETF client would like to have.

Alas, I’m fairly certain these fund managers would argue that the AAA –> BBB tranches are indeed liquid enough for an ETF to function normally. And that may indeed be the case given the small fund sizes within these ETF offerings today. However it would be prudent for a holder of CLOs via ETF to consider this a risk in excess of the same risk in a large cap equity ETF (or similar deeply liquid collateral base).

Additionally and obviously, given these are actively managed ETFs, one has to consider the risk that the manager makes poor decisions that cause underperformance vs. the benchmark.

CLO Equity

Separate from owning rated CLO debt tranches, the ability for an investor to own CLO equity has been available for the past ~5 years. And distinct from CLO debt tranches, the equity tranches almost exclusively reside within CEF structures, interval funds, or private funds.

I believe PIMCO most aptly described the case for CLO equity:

Although CLOs are complex instruments, CLO equity can be boiled down into two key return drivers: a call on credit spreads and a call on the assets of the transaction. Each of these options needs to be valued within a unified risk framework that considers bottom-up credit factors as well as the top-down macroeconomic environment. While the mark-to-market risk of CLO equity is acute, hold-to-maturity investors can benefit from a robust and stable return profile. Unlike most alternative investments, CLO equity cash flows tend to be front-loaded, typically providing investors with current cash and reducing cost basis early in an investment life cycle. 

For this reason, an opportunistic CLO strategy can serve as a complement alongside other longer-lockup investments. Many long lock-up investments, such as private equity or venture capital funds, generate back-end return profiles, so an allocation to CLO equity can smooth return profiles within broader alternatives buckets by providing front-end-loaded returns. A CLO-driven approach can also serve as an offset for higher-credit-beta investments, since it can potentially capitalize on a widening spread environment.

Again, while up to the investor to decide suitability, CLO equity is a unique product that doesn’t have many analogues. Perhaps the most appropriate analogue for retail public market investors is leveraged loan BDCs (LLBDC). Often times the LLBDC manager is also a prolific CLO manager. LLBDCs typically hold about 40-60% of their capital structure in debt, with LLBDC equity (the publicly traded equity stub) comprising the rest. By contrast, CLOs typically utilize debt for 90% of their asset base, leaving the last 10% for the CLO equity investor, a much more leveraged approach to capturing the earnings in excess of debt service (and expenses).

Regardless, the punch line on the retail investor’s options when it comes to CLO equity, is they are…not great. This is for a number of reasons.

For one, each individual CLO has a CLO manager who typically owns a portion of the CLO equity. That manager often takes a 0.40% management fee, along with an incentive fee of 20% over a 12% hurdle. The publicly traded CLO equity security often comprises of a bundle of many CLO equity securities, giving an investor diversification across CLO vehicles / managers. The publicly traded security will also take another more hefty fee layer – often a management fee north of 1.5% and an incentive fee of ~20% over an 8% hurdle with an aggressive catch-up clause. While there are often fee rebates / waivers that occur across CLO equity deals one can presume that the worst case is a large chunk of potential upside outperformance is mowed down by layers of incentive and management fees while downside scenarios are fully borne by the retail investor.

Last, the publicly traded CLO securities often employ substantial leverage. Remember, I outlined that CLO equity already has implied ~10x leverage. These CLO CEFs and interval funds often employ an additional 30% of debt to total assets, raising the total leverage of a CLO CEF / interval fund to ~14x. Yikes. Why do they do this? Fees seem to be the most realistic answer. One can charge the biggest fee structures when the return profile is leveraged up to be accordingly high.

When you put together high leverage and a historically low default environment over the past 5 years, these CLO equity vehicles give the appearance of a high return proposition. So much so that they often trade materially above their self-published NAV. Eye watering dividend yields pull in a certain kind of retail investor that cannot resist the squeeze despite the disadvantaged setup. While I believe that CLO equity may make for an interesting allocation without aggressive fee layers, that is not readily available to a retail investor today.

Conclusions

While I don’t believe that CLOs are any sort of holy grail of investing, I do believe they remain an under-appreciated tool to create outcomes that align with certain investors’ goals, especially in an environment with increased interest rate focus.

CLO debt ETFs, a new kid on the block, have opened a new asset class that doesn’t appear to be a collective grift that robs the retail investor, a good thing! Targeted ETFs now exist that enable surgical fine tuning to different risk profiles / ratings classes. Furthermore the underlying loan diversification allows the retail investor to get exposure to the overall credit performance of a certain tranche versus being heavily biased to manager asset selection.

Retail CLO equity vehicles appear to be a way to play the CLO structure with one’s shoes tied together. In time, one can hope that more investor-aligned vehicles come to market. Today, one can access a similar product (but far from the same) via LLBDCs, which effectively incorporate a sandwich of the equity layer plus the A, BBB, and BB layers of a CLO, without the more conservative and lower fee CLO structure.

Until there is a change in the winds in which banks have an incentive to hold more loans on their books, vehicles like CLOs will continue to be a mainstay of the credit landscape, and at the very least, it is worthwhile for investors to understand how CLOs among other floating rate credit products can be tool in the overall tool-belt.

Disclosure: Author does not own any of securities mentioned at time of writing. This is not investment advice, do your own work.