The Growing Popularity of CLO ETFs

Growing Popularity of CLO ETFs

The $1.2 trillion collateralized loan obligations (CLOs) market is increasingly attracting individual investors and financial advisors through exchange-traded funds (ETFs). These ETFs offer exposure to CLOs, providing an alternative income source with yields above risk-free rates.¹ As more investors recognize the security and yield potential of CLOs, demand for CLO-focused ETFs may continue to rise.

Understanding CLOs and Their Appeal

CLOs are investment vehicles that pool together floating-rate corporate loans that are both senior and secured on corporate balance sheets.¹ They are structured in tranches, each with varying levels of risk and return:

• Senior Tranches (AAA-rated): have first claim on cash flows and are generally considered the safest, with historically zero defaults.¹

• Lower Tranches (BB and BBB-rated): offer higher yields but come with increased risk.¹

It's important to distinguish CLOs from the collateralized debt obligations (CDOs) that contributed to the 2008 financial crisis. Unlike CDOs, which held subprime mortgages and were less regulated, CLOs are more regulated, transparent, and generally consist of higher-quality assets.² The underlying assets in CLOs are leveraged loans, also known as senior loans, which are secured by collateral and have higher recovery rates in case of default.²

John Kim, CEO at Panagram Structured Asset Management, emphasizes the focus on credit spread over the risk-free rate:

"They are floating, and in a rising-rate environment you get more yield. But absolute yield is not what you should be thinking about; you should look at how much extra yield you get over the risk-free rate."¹

This means that while CLOs benefit from rising interest rates due to their floating-rate nature, the real attraction lies in the additional yield they offer over risk-free securities.

Growth of CLO ETFs

There are currently fewer than a dozen ETFs offering exposure to CLOs, but their assets under management (AUM) are growing:¹ ² ³

• Janus Henderson AAA CLO ETF (JAAA): Dominant player with $6.8 billion in AUM since its launch in October 2020.¹

• Panagram BBB-B CLO ETF (CLOZ): Launched in January 2023, has grown to $220 million.¹

• Panagram AAA CLO ETF (CLOX): Launched in July 2023, currently at $55 million.¹

• BlackRock AAA CLO ETF (CLOA): Reached $103 million since January 2023 launch.¹

• Invesco AAA CLO Floating Rate Note ETF (ICLO): At $58 million since December 2022 launch.¹

These ETFs provide investors with access to the CLO market with the transparency, liquidity, and accessibility of an ETF wrapper.² The growth in AUM reflects increasing investor interest in CLOs as a means to achieve higher yields while managing interest rate risk.

Panagram Structured Asset Management, which manages nearly $16 billion worth of CLO portfolios mostly for institutional investors, entered the ETF space to give retail investors access to this otherwise obscure asset class.¹ The firm's ETFs, CLOZ and CLOX, cater to different risk appetites by focusing on different tranches of CLOs. SOURCE

Potential Advantages of Investing in CLO ETFs

Higher Yields

• AAA-rated CLOs are currently yielding around 6.5%, about 120 basis points over the risk-free Secured Overnight Funding Rate (SOFR).¹

• BB and BBB-rated CLOs can yield nearly 10%.¹

These yields are attractive compared to traditional fixed-income securities, providing investors with enhanced income potential.

Lower Interest Rate Risk

CLOs have floating rates, which adjust with changes in interest rates, reducing interest rate risk.² In a rising-rate environment, the yields on CLOs increase, providing a hedge against inflation and interest rate hikes.

Portfolio Diversification

CLOs have less than 50% correlation to a 60/40 portfolio, offering diversification benefits.¹ This low correlation means that CLOs can help reduce overall portfolio volatility and enhance risk-adjusted returns.

Security

There has never been a default in AAA-rated CLO tranches.² Even during financial crises, CLOs have shown resilience. For instance, during the 2008 financial crisis, while CDOs collapsed, CLOs performed relatively well.²

Access to Institutional Markets

CLO ETFs democratize access to the institutional CLO market, allowing retail investors to invest similarly to institutional investors. Previously, investing in CLOs was limited to large, sophisticated investors due to complexity and high minimum investment requirements. SOURCE

CLO ETFs as Prudent Yield Opportunities

According to Bank of America, CLO ETFs present "prudent yield" opportunities, offering yields ranging from 6-9% depending on credit quality, which is well above the 4-5% yields in traditional fixed-income products.³ CLOs' floating-rate nature has bolstered performance in a higher-for-longer rates backdrop.

Bank of America noted:

"Collateralized loan obligations (CLOs) are a perfect example of Prudent Yield. CLO ETF yields range from 6-9% depending on credit quality, well above 4-5% yield in traditional fixed income products."³

This highlights the attractiveness of CLO ETFs in the current interest rate environment, where investors are seeking higher yields without taking on excessive risk.

Implications for Investors

The growing popularity of CLO ETFs has several implications for investors:

Enhanced Income Potential

Investors can achieve higher yields compared to traditional fixed-income securities, benefiting from the credit spread over risk-free rates. This is particularly appealing in a low-yield environment where finding reliable income sources is challenging.

Interest Rate Hedge

The floating-rate feature of CLOs provides a hedge against rising interest rates, as yields adjust upward with rate increases. This can protect investors from the price declines typically associated with fixed-rate bonds when interest rates rise.

Portfolio Diversification

Adding CLO ETFs can reduce portfolio volatility due to their low correlation with traditional asset classes. This diversification can improve the overall risk-return profile of an investment portfolio.

Access to Institutional Markets

CLO ETFs democratize access to the institutional CLO market, allowing retail investors to participate in an asset class that was previously difficult to access. This opens up new opportunities for portfolio enhancement.

Risk Considerations

While AAA-rated CLOs have a strong track record, lower-rated tranches carry higher risk. Investors should assess their risk tolerance and understand the underlying assets. Lower tranches may offer higher yields but come with increased risk of default.

Market Education

As CLOs are complex instruments, investors may need to invest time in understanding the structure and risks associated with CLO ETFs. Proper due diligence and possibly consultation with financial advisors are recommended.

Conclusion

The CLO market's expansion into the ETF space offers investors a compelling opportunity to enhance income and diversify portfolios. With yields exceeding those of traditional fixed-income assets and a history of strong performance, CLO ETFs are carving out a niche among both retail and institutional investors.

As the market evolves, continued education and understanding of CLOs will be essential for investors looking to capitalize on these benefits. The combination of high yields, interest rate protection, and portfolio diversification can make CLO ETFs an attractive option in today's economic landscape.

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_{1. ETF.com, ETFs Focused on Collateralized Loan Obligations Rise, 2024.}

_{2. ETF Central, Tony's ETF Buyers Guide: Collateralized Loan Obligation (CLO) ETFs, 2024.}

_{3. Yahoo Finance, Growing Interest in CLO ETFs Among Investors, 2024.}

_{The content herein is solely for informational purposes and should not be viewed as investment or any other advice or a current or past recommendation, or an offer to sell or the solicitation to buy securities or adopt any investment strategy. Certain of this material has been generated by an artificial intelligence language model, ChatGPT, which has been prompted to provide topical finance-related articles. The articles herein may not reflect the most current news, events, or developments. While we strive for accuracy, there may be limitations, inaccuracies, or biases present, and The Buyside Journal (including, for the avoidance of doubt, its affiliates) assumes no liability for the content herein and does not guarantee the accuracy, adequacy or completeness of such information (and does not undertake any duty to correct or update such information). Readers are encouraged to independently verify the information herein and consult with professionals for specific advice or information. Predictions, opinions, and other information contained herein are subject to change continually and without notice of any kind and to the extent accurate initially may no longer be true after the date indicated. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward-looking statements.}