Driven by an environment of elevated yields and ample carry opportunities, the bond bull market that began in late 2022 is set to extend into a fourth year. Yet, with credit spreads now tighter than historical norms, investors are increasingly turning to collateralised loan obligations (CLOs) – an asset class offering higher yields and attractive risk-adjusted returns, which is expanding beyond its institutional roots at an opportune time.
Put simply, CLOs are fixed-income securities consisting of aggregated corporate loans. Each CLO diversifies across 250 to 450 senior secured loans from various corporate issuers, which are segmented into ‘tranches’ based on subordination and income priority.
Catering to a range of investor appetites, AAA tranches sit at the top of the capital structure and are considered the most risk-remote, while lower-rated tranches offer higher yields but carry greater risk.
A common misconception among investors is confusing CLOs with CDOs, the highly complex instruments made infamous during the 2008 global financial crisis. A key differentiator is collateral.
CLOs are backed by diversified, transparent corporate credit, often from large, well-known companies. This robust collateral base offers greater protection and comfort versus legacy securitisations such as subprime mortgages.
Higher yields and low correlations
With momentum building since the late 1990s, the CLO market is now a $1.4trn asset class. Renowned for low correlations with traditional fixed income sectors and equities, CLOs generally offer higher yields than comparably rated corporate bonds in the US and Europe. In fact, AAA CLOs continue to display some of the widest spreads among investment-grade assets – but with far less duration risk.
For investors seeking to enhance yield with minimal credit risk, AAA CLOs offer a compelling alternative to traditional holdings like government bonds and corporate debt.
However, rather than simply replacing core bond allocations, AAA CLOs are gaining appeal as a complementary holding to improve a portfolio’s overall efficiency and diversification.
For example, allocating AAA CLOs to a traditional bond portfolio has historically improved risk-adjusted returns, especially during periods of market stress or rate uncertainty.
CLOs are a core building block in portfolio construction and have historically had allocations that range from 5% to 30% depending on the strategy.
Zero defaults in three decades
The recent significant pick-up in demand is relatively easy to explain, as CLOs mitigate the two primary risks in fixed income: interest rate risk and credit risk. CLOs carry very low duration, with floating-rate coupons that adjust with changes in short-term interest rates. The low duration shields the assets from interest rate shifts that can trigger significant drawdowns in rate-sensitive sectors, such as government bonds.
As mentioned, CLO tranches offer different degrees of credit risk, with the AAA-rated tranche comprising the highest-quality loans. The CLO structure provides added protection by prioritising repayment from the top down.
Losses impact senior tranches only after buffers from lower-rated tranches are exhausted. This waterfall structure makes AAA CLOs exceptionally resilient. In fact, AAA and AA CLO tranches have not experienced a single default in more than 30 years of market history.
Resilience in times of stress
During the Covid-19 market selloff, CLOs continued to trade actively, even as other credit markets froze. This liquidity, combined with structural performance tests that divert cashflows to senior tranches during periods of market stress, makes AAA CLOs exceptionally robust.
The tariff-driven volatility in April served as another critical stress test for the CLO market. Overall, the asset class held up well, but the event highlighted notable differences in fund performance.
Managers who resisted chasing higher yields during tight spreads and instead maintained more conservative portfolios were better positioned to weather the turbulence.
Conservative portfolios experienced less volatility, narrower discounts to net asset value (NAV) and stronger total returns during the worst of the drawdown. While the episode was short-lived, it underscored the importance of prudent management.
The importance of going global
As the CLO market attracts a broader audience seeking yield and diversification, having a wide universe of investable assets is imperative. While the US market is dominant in terms of size, European CLOs often trade at wider spreads due to differences in regulation that leads to greater market segmentation.
This was evident during the UK gilt crisis. At that time, European CLO prices fell amid local liquidity pressures, while US markets remained stable.
The US market also benefits from a larger retail and insurance investor base, ensuring consistent bid support and robust secondary market activity.
For global fund managers, access to both markets enhances portfolio flexibility, optimises liquidity management, and expands investment opportunities across credit cycles.
Edwin Wilches is portfolio manager of the PGIM Global AAA CLO fund. The views expressed above should not be taken as investment advice.