CLOs offer an attractive and scalable opportunity to gain exposure to highly-rated floating-rate assets with attractive spreads.
As the market ponders a higher-for-longer interest rate environment, floating-rate assets continue to garner investor attention. Collateralized Loan Obligations (CLOs), which are securitizations backed by diversified pools of high-yield corporate leveraged loans, offer an attractive and scalable opportunity to gain exposure to highly-rated floating-rate assets with attractive spreads.
Spreads and Yields in CLOs
Given the elevated nature of policy rates, CLOs offer relatively higher current yields compared to other investment options with similar ratings. Furthermore, given the size of the CLO market, there is a spectrum of various Weighted Average Life (WAL) profiles to choose from, allowing investors to take shorter spread duration exposure if desired. CLO spreads are approaching post-GFC (Global Financial Crisis) tights, but that is not unique to the sector; many spread products are fairly tight relative to their historical ranges. Shorter WAL CLOs offer an interesting opportunity to benefit from attractive carry while minimizing potential drawdowns in the event of spread widening.
Scalability
With almost $1trn in outstanding volume, the US CLO market is the most scalable way to source investment-grade (IG) rated, floating-rate bonds. Leveraged loans, which provide the underlying collateral for the CLO market, are the single largest floating-rate asset class by outstanding volume (~$1.5trn), but the entire sector is rated non-IG. The floating rate portion of the investment-grade corporate market is also significant at ~$635B, but the IG portion of the CLO market is still larger.
Within the securitized credit market, there are other sectors that offer floating-rate securities, including the Credit Risk Transfer (non-agency residential mortgages) and Commercial Real Estate CLO sectors, but these sectors are smaller and have sporadic issuance. In addition to being larger and offering more programmatic primary issuance, the CLO new issue market offers a wider range of spread durations from which to choose.
Robust Structure
CLOs have structural protections including: tests that help maintain the quality and maturity profile of the underlying loan portfolio over time; credit enhancement that provides a cushion from losses on the loans; and triggers that divert cashflow from more junior tranches to the top of the capital structure if performance deteriorates. Historical default rates on CLOs are low despite a wider range of default experiences in the leveraged loan market. This stronger default performance is due to CLO managers’ proactive portfolio management, benefitting from the ability to trade in a liquid secondary loan market.
With the expectation that rates may remain higher for longer, floating-rate securities continue to look attractive. The CLO market offers a scalable opportunity to add floating-rate, investment-grade rated bonds in a robust structure that was tested not only through the GFC, but also more recent periods of stress in 2020 and 2022-2023. CLO tranches have a variety of ratings and spread durations to choose from, allowing investors a range of options to best suit their unique needs, while still generating higher yields than other investments with the same rating.