Amid a ‘higher-for-longer’ interest rate environment and Federal Reserve uncertainty, investors poured $2.3 billion into collateralized loan obligations (CLOs) in July, bringing year-to-date inflows to $11.8 billion. These floating-rate instruments, which have outperformed other fixed-income assets, are gaining popularity as experts like John Kerschner of Janus Henderson and Cathy Bevan of Benefit Street Partners highlight their attractive yields and diversification benefits, especially for investors willing to navigate their inherent risks.
Investors are increasingly turning to collateralized loan obligations (CLOs), a segment of the bond market known for its higher risk and attractive yields, as they navigate a persistently elevated interest rate environment. In July alone, a significant $2.3 billion flowed into CLO exchange-traded funds, pushing the year-to-date inflows to a substantial $11.8 billion, according to data from LSEG.
CLOs are essentially securitized pools comprised of floating-rate loans issued to businesses. Their structure makes them particularly appealing when interest rates are high, as their coupon payments adjust in tandem with short-term rate changes. This characteristic has allowed CLOs to outperform other fixed-income assets during the first half of the year, as highlighted by Janus Henderson.
The Federal Reserve's monetary policy continues to keep interest rates elevated, with the central bank holding steady after delivering prior rate cuts. Some officials have even advocated for rate increases as early as September, with three members voting for a hike at the last meeting. Market sentiment for rate increases has softened somewhat following a weaker jobs report, but CME FedWatch data still indicates a 50% probability of a September hike. The upcoming consumer price index (CPI) reading on Wednesday is anticipated to be a crucial factor in the Fed's decision.
John Kerschner, global head of securitized products at Janus Henderson, strongly advocates for including CLOs in an investor's portfolio regardless of the interest rate climate. "We don't recommend people time the market," Kerschner stated, emphasizing their role as a strong diversifier offering good yield and consistent performance. He suggests CLOs only become problematic if the United States plunges into a recession, leading to a sudden drop in rates.
Cathy Bevan, global head of structured credit at Benefit Street Partners and co-manager of the recently launched Franklin BSP CLO ETF (YCLO), echoes this sentiment, believing CLOs currently offer compelling value. She notes that despite high demand for various tranches (slices of loan pools), the robust supply is creating attractive yield opportunities compared to equivalent corporate credit risks. YCLO, launched in June, currently boasts a 30-day SEC yield of 4.46%.
For investors considering CLOs, they can serve as an effective portfolio diversifier and yield enhancer but should not constitute the majority of fixed-income holdings. The allocation depends heavily on an individual investor's risk tolerance. While moving down in ratings can unlock higher yields, AAA-rated CLOs offer the highest seniority in case of borrower bankruptcy, making them the recommended choice for most individual investors, according to Kerschner.
The Janus Henderson AAA CLO ETF (JAAA) has attracted $5.73 billion in inflows this year, holds approximately $30 billion in assets under management, and features a 30-day SEC yield of 4.87% with a net expense ratio of 0.20%.
For those with a higher risk appetite and a deeper understanding of the asset class, Janus Henderson also offers a B-BBB CLO ETF (JBBB). Although its underlying assets are still considered investment grade, their lower ratings imply greater risk. JBBB has seen $260 million in inflows, bringing its total assets under management to $1.44 billion, and offers a more substantial 5.97% 30-day SEC yield, albeit with a higher net expense ratio of 0.47%.
"You probably don't need that couple hundred basis points' yield, given the amount of volatility it's going to give you," Kerschner cautioned, advising that most investors take their volatility exposure from equities. However, for those aiming to maximize yield relative to a given risk, BBB-rated CLOs might be suitable, provided investors "understand the use case for them" and are "not taken for a ride they're not prepared for."
