2/15/2021 Collateralized Loan Obligations Are Now Available in ETFs. Should You Buy?

| Barron's

ETFS

Another Fixed-Income Niche Is Now

Available in ETFs. Should You Buy?
By Evie Liu Oct. 20, 2020 5:00 am ET

The exchange-traded fund industry

has just cracked open another
niche area previously only available
to professional investors:
collateralized loan obligations. But
just because you can invest in
something, should you?

Collateralized loan obligations, or

Sam74100/Dreamstime
CLOs, are securities backed by a
pool of corporate loans. The market for them has grown larger and more liquid over
the past few years, and now seems mature enough for wider adoption. Alternative
Access Funds—a start-up fund manager founded in 2018—launched the $10
million AAF First Priority CLO Bond ETF (ticker: AAA) in September. The Janus
Henderson AAA CLO ETF (JAAA)—with much larger seed assets of $120 million—
began trading Monday.

Many investors might associate CLOs with CDOs, or collateralized debt obligations,
which earned a great deal of notoriety due to their leading role in the last financial
crisis. The two instruments are similar in that they both bundle debt and sell to
investors in slices, but different in their underlying offerings.

CDOs are pools of mortgages issued to consumers; while CLOs are composed of
loans made by banks to businesses—often with higher debt loads or lower credit
ratings. The market is more heavily regulated, with a long history of credit-risk
rating and stress tests from agencies like Moody’s and S&P Global. Each loan can
make up no more than 2.5% of a CLO portfolio to ensure diversification, and is
evaluated based on the issuer’s financial health.

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The bundle is then sold to investors under different tranches with varying risks and
returns. The AAA-rated tranches, for example, are paid out first when the underlying
loan payments are received, and therefore generate less yields than lower-rated
tranches with higher chances of default losses.

“The default risk of CLOs is extremely low, even much better than many corporate
high-yield bonds,” says Wells Fargo CLO analyst David Preston. Of the more than
12,500 CLO tranches rated by the S&P Global, only 40 have ever defaulted—and
none of them were AAA-rated, where the two new ETFs primarily invest.

As the coronavirus pandemic ignited a fresh wave of scrutiny on the financial

health of companies, thousands of leveraged loans and hundreds of CLOs were
placed under review or downgraded in ratings. None of that has affected the AAA-
rated tranches.

Since the last financial crisis, more features have been put in place to give highly
rated CLO tranches more protection. When default rate increases, for example,
more of the loan issuers’ cash flow will be reallocated to AAA-rated tranches to
prevent them from incurring losses. “Cash flow pays down from the top, and
defaults eat away from the bottom,” Preston says.

The layered structure of CLOs means that principals in the AAA-rated tranches will
be protected until more than 70% of the underlying loans have defaulted, assuming
half of the value could be recovered. Even in the midst of the 2009 financial crisis,
the default rate was only 10%.

Of course, low default risk doesn’t mean highly rated CLOs don’t have other risks
involved. Just like any fixed-income instrument, they tend to be less liquid than
stocks.

Traditionally, banks and insurers were the major holders of highly rated CLO
tranches. Since they tend to be long-term investors that don’t trade frequently,
liquidity was very limited. “There was no secondary market for CLOs; they could
only be bought at issuance and only large institutional investors had access,” says
Janus Henderson’s ETF head Nick Cherney, “They were also traded at very large
sizes, typically $1 million to $5 million.”

Liquidity has improved significantly over the past five years. When the Federal
Reserve started to raise interest rates in 2015 after years of near-zero rates, floating-
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rate assets like leveraged loans and CLOs became more attractive among income-
seeking investors. Loan issuance exploded and CLOs took in huge chunks of those
loans. The collateralized loan market size has ballooned from $400 billion in 2015
to more than $700 billion today.

As money managers have become buyers and sellers of CLOs, trading volume on
the secondary market has increased significantly. This has enabled the launch of
retail-oriented products like ETFs. The AAF and Janus Henderson CLO ETFs are
both actively managed and only invest in the highest-rated tranches. Both own
more than 30 CLOs, and charge an expense ratio of 0.25%.

Although these ETFs now make CLOs accessible to all investors, they might be not
ideal for all.

Investors interested in leveraged loans have long had access through funds like
the $4.3 billion Invesco Senior Loan ETF (BKLN) and the $1.7 billion SPDR
Blackstone/GSO Senior Loan ETF (SRLN). But critics of these products often warn
of the declining lending standard and credit quality in bank loans over the past
decade, driven by investors’ eagerness for higher yields in a low-rate environment.

This includes the growth of so-called covenant-lite loans carrying fewer lender
protections, allowing borrowers to stay highly leveraged without being forced into
default. A February 2020 report from S&P Global points out that recovery rates of
first-lien leveraged loans have been in the neighborhood of 75% to 80% historically,
but due to increased corporate leverage, it might decrease to the mid-60s during
the next economic downturn—which could be right now.

Closed-end mutual funds that invest in lower-rated, riskier CLO tranches are
reflecting the market’s concern. CLO equity fund Eagle Point Credit (ECC) is down
41% year to date, and CLO subordinated-bond fund Eagle Point Income (EIC) has
declined 30%—although both funds have rebounded from their March lows.

To be sure, AAA-rated CLOs and the new ETFs investing in them offer the much
safer corners of the leveraged-loan market, with layers of default protection yet
higher yields than investment-grade bonds. As of Sept. 30, the average yield of
AAA-rated CLOs was 1.6%, more than double the 0.78% yield of AAA-rated
corporate bonds.

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Still, it remains an open question how well the secondary market for CLOs will fare
if the underlying loan market deteriorates. For niche investments like this, if an
economic downturn hits, they can still suffer price volatility when the market sells
off and liquidity dries up—even if they avoid catastrophic principal loss.

To achieve wider adoption, the asset class needs time to prove itself as a reliable
alternative to other fixed-income instruments in a low-rate environment. After all,
the burn from 2009 still hurts today.

Write to Evie Liu at evie.liu@barrons.com

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