Investing in CLOs through an ETF

Investing in Collateralized Loan Obligations (CLOs) is a fixed income investment strategy that, until recently, was mostly available only to the largest institutional investors. However, with the introduction of CLOs to ETFs, more investors can now gain access to both the asset class, and, through BlackRock, the same institutional quality portfolio management teams used by our institutional investors. ETFs can provide low costs, daily liquidity, portfolio transparency, and diligent risk management.

To help more investors gain comfort with this type of investment, this article will cover:

• What a CLO is (and is not).
• How they can offer higher yields and what are their risks.
• Why an experienced manager is paramount.
• How investors are using CLO ETFs.

In its simplest form, a CLO holds a pool of potentially higher yielding and lower rated loans, where the priority of cash flows received from those loans, and therefore their risk, is allocated across a mix of investor’s risk and return profiles through a process called “tranching”. The most risk adverse investors typically invest in the first and highest rated tranche, receiving their cash first and are last to suffer from any losses. The last and lower rated tranches are allocated the earliest credit losses incurred by the loan pool and are only paid after all other promised cashflows, when available, are paid to the first ones. The first and most protected tranche is typically rated AAA by major rating agencies, with less protected tranches given lower ratings, from AA to B or below.

Securitization is common in fixed income markets, but not all tranche structures are the same. Given their name, CLOs are often confused with collateralized debt obligations (“CDOs”), or other structured securities often associated with the Global Financial Crisis (GFC). CLOs differ from CDOs in what they own, the diversification of the loan pool, structural features that protect investors, and their history. Notably, no AAA-rated CLO has ever defaulted.² In fact, given how the typical CLO is structured, more than half of the underlying loans would need to default before the AAA-rated tranche would begin to experience losses.³

Today, CLOs have matured to a $1.2tn market globally, roughly the same size as the $1.2tn US High Yield bond market.⁴ As investors may allocate a portion of their portfolios to high yield bonds seeking potential income and return, CLOs could be a consideration as well.

Given their limited investor base, along with the memories of those other structured securities in the GFC, AAA CLOs have offered a higher yield relative to similarly rated corporate debt.  As of 12/31/23, AAA CLOs yielded (YTM) 7.0%, a sizable premium to the 4.5% for AAA-rated corporates.⁵ CLOs are also floating rate securities, meaning if interest rates move higher, CLO coupon payments could be reset to higher rates, or could reset lower if interest rates fall.

In addition to higher yields, CLOs have also historically exhibited lower volatility and have realized lower drawdowns in market stress. In the last ten years, AAA CLOs realized a volatility of 1.9% while AAA corporates realized volatility of 8.1%.⁶ As mentioned above, no AAA-rated CLO has ever defaulted in the history of the asset class.⁷

So, what’s the catch?  Despite displaying little credit risk, CLO spreads can widen with broader market volatility, asset allocation shifts by large holders, and other factors, leading to price declines and to negative performance. The largest drawdown experienced by AAA CLOs in the last 10 years was -10% using daily returns and -5% using monthly returns, in line with shorter duration markets and smaller than other fixed income sectors.

CLOs differ from more traditional fixed income securities in their risks, liquidity, trading, and type of investors, requiring a knowledgeable portfolio management team to navigate these nuances. BlackRock is one of the largest asset managers in the CLO market, overseeing $32bn of CLO tranches by our dedicated CLO team. We believe our team’s advantage and expertise is differentiated by its rigorous investment process—inclusive of an in-depth evaluation of structures, underlying collateral and assessing relative value opportunities—and also its access to advanced analytics through our Aladdin risk platform.

Given their relatively high yields in today’s market⁹, lack of duration risk, and historically low volatility¹⁰, investors have used AAA CLOs to help diversify their income buckets or in their capital preservation allocations. Today, we see investors using CLOs to increase the yield in their portfolios without reducing credit quality.¹¹

Whether it is a first-time allocation to this asset class or leveraging the benefits of a daily liquidity vehicle with low investment minimums, the ETF is now providing more investors access to — and expertise in — this growing asset class.