Our 8-10% Yielding Picks And Pans In The CLO Sector

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The Collateralized Loan Obligation or CLO sector remains a compelling one for income investors for all the usual reasons. These include high absolute yields, high yields relative to underlying credit quality and resilient performance through market drawdowns.

In this article, we run through different options to allocate to this income sector. They range from private funds / managed accounts, CLO Equity CEFs, CEF preferreds and baby bonds, CLO Debt ETFs and partial-allocation CLO Equity / Debt funds.

Given the risk/reward on offer, we prefer to stick with CLO Equity CEF baby bonds trading at yields around 8% as well as crossover-rated (i.e. low investment-grade / high sub-investment grade rated) CLO Debt securities in an ETF wrapper.

Why CLOs Remain Compelling Income Assets

This article is not going to be a CLO primer – there are good sources readily available on the internet. We will only sketch the broad outlines of a CLO for the purpose of this article.

A CLO is just the combination of a portfolio of loans (i.e. the asset portion of the CLO) and a set of liabilities (i.e. the bits that are called CLO Debt). The CLO Debt securities (also called tranches) have a varying number of protections and collateralization which is why some can be rated AAA and others B/BB despite referencing the same portfolio of loans. As expected, the higher the tranche in the capital structure the less risk it carries and the lower its yield. The difference between the CLO assets and its liabilities is, unsurprisingly, called CLO Equity and this tranche earns the excess spread that the loan assets deliver over its liabilities i.e. its CLO Debt.

CLO Equity has two basic attractions. First, its very high yield across the entire credit market with implied yields often around 15%+. And two, its robust performance across market meltdowns, something that is not totally intuitive but remains a fact of the asset class.

CLO Debt also has two similar attractive features. One, is its high yield in both absolute terms as well as relative to similarly rated corporate debt. For instance, BBB CLO Debt securities traded at credit spreads of around 4-6% in December of last year versus credit spreads sub-2% for BBB-rated corporate debt. It’s also important to highlight that CLO Debt securities are floating-rate so their yields have increased in line with the rise in short-term rates – an attractive feature in the current market.

One would think that such a high spread premium means CLO Debt has a worse historical default profile, however, that’s not actually the case as the following table shows. In fact, CLO Debt securities have a significantly lower default rate than similarly rated corporate debt. One risk that’s always worth highlighting is that the worst-case scenario for a CLO Debt security is worse than for a portfolio of corporate bonds because of the way the CLO structure works.

It should also be said that today’s loan market is arguably riskier than in the past. We can see this in an overall downward rating migration over time as well as a greater use of covenant-lite structures. This does increase the risk of CLO securities; however, it is partly mitigated by the continued evolution of CLO structures themselves – we are now on version 3.0.

Investor Options in the CLO Space

Let’s go through the different investment options in the sector:

• Private funds / managed accounts are offered to more sophisticated / higher net-worth retail and institutional clients by many credit managers such as Ares, Barings and others. Retail investors typically don’t have access to these funds so we don’t focus on them here.
• CLO Equity CEFs are the popular vehicles such as OXLC, ECC, OCCI, EIC and tend to boast very high yields of around 10-20% or so.
• Preferreds are a lower-beta and lower-risk way to allocate to the CLO space. CLO Equity CEF preferreds are trading at yields of 8-9% while CLO Debt / partial CLO CEF preferreds trade at yields of around 6.5-7%. There is about a dozen securities in this bucket.
• Baby bonds are a further up-in-quality way to allocate to the CLO Equity space. The handful of baby bonds trade at yields around 8%. These include ECCV, ECCW, ECCX, OXLCL, OXLCZ.
• Partial allocation CEFs are funds like ARDC, XFLT and others that hold vanilla credit assets such as bank loans and corporate bonds alongside CLO securities. This combination makes for a kind of lower-beta / CLO-lite profile for investors who don’t want a full-on CLO offering
• CLO Debt ETFs span the CLO Debt quality spectrum from funds that allocate to the highest-quality tranches such as JAAA, CLOA and CLOI as well as lower (but still decent) quality options such as JBBB and CLOZ.

Our CLO Picks

At the moment, we don’t like outright CLO Equity exposure via CEFs for two reasons. One is valuation, both in underlying credit markets as well as CLO Equity CEF discounts. Over 2022 we highlighted OXLC as a tactical option whenever it traded down towards a $5 price and a zeroish premium – at current price and premium level it’s much less appealing. And two, anecdotal evidence suggests that many CLO Equity private / managed funds have delivered significantly stronger returns than CEFs and investors who have access to this part of the market should explore it.

We also view the yield differential between CLO Equity baby bonds and preferreds as too narrow (recall, the bonds are trading around yields of 8% versus yields of 8-9% for the preferreds). This narrow differential and a relatively high absolute yield means we continue to find baby bonds very attractive holdings both in the CLO space as well as in the broader income market. We particularly like the pair of OXLC baby bonds (OXLCL) and (OXLCZ), both trading at yields of around 7.8%. We should also note that among the ECC and OXLC baby bonds, we prefer OXLC ones due to significantly higher asset coverage.

We also continue to like holding CLO Debt via ETFs. For investors looking for a very high-quality option we like the low-fee BlackRock AAA CLO ETF (CLOA). The fund has a 6.6% yield-to-maturity portfolio alongside a 0.2% fee – very attractive for an ultra high-quality portfolio.

Somewhat lower down the quality spectrum we like the Janus Henderson B-BBB CLO ETF (JBBB). The fund has a 10.2% yield-to-worst.

Finally, investors who want to stick with the CEF structure without the full tilt to CLOs, should have a look at the Ares Dynamic Credit Allocation Fund (ARDC) which has an 8% CLO Equity and 22% CLO Debt allocation. ARDC trades at a 12.8% discount and a 10.8% current yield. The fund has raised its distribution twice in the past year.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.