Talk Your Book: Floating Rate Income
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Today's Animal Spirits Talk Your Book is brought to you by VanEck. Go to VanEck.com to learn more about their VanEck CLO ETF. That's ticker CLOI. It's VanEck.com to learn more.

Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

Welcome to Animal Spirits with Michael and Ben. On today's show, we are talking about collateralized loan obligations. Wait, isn't that what almost took down the financial system in 2008? No, not exactly. Those were collateralized debt obligations. Some of them might have been inside CLOs, Ben. I don't know. It's been a long time. I haven't read Too Big to Fail in 20 years. I read a lot of very long magazine pieces about this stuff back then because there weren't really blogs and stuff to get into this.

But yeah, I think anything with the word collateralized in it probably has people feeling a little nervous. Thank you for not checking my math there. Okay. A little bit off. So we talked to Fran and Bill from VanEck today, who work for their fixed income ETF portfolio management team. We talked about CLOI, which is a collateralized loan obligation ETF, which is obviously making way in the headspace of investors because this thing went from zero to a billion in like the last decade.

Three years, I guess. Unbelievable. So it's essentially, it's a basket of loans that invests in a basket of loans. Yes. Baskets all the way down. And there's higher, hearing about the products is interesting. It just made me think how many different ways, you think of fixed income as like this really boring asset class to invest in. Oh, you just buy government bonds and that's it.

And now there's so many other ways to invest. And I think the fact that we've had so much extreme volatility in bonds over these, in this decade has made people try to rethink, wait, maybe I need a little bit of this or some of that and try to hedge different environments. Well, guess what? The appeal to this is it's actually not fixed income. Right. Oh, because it's floating rate. Right. Right. So yeah, when rates go up and inflation goes up, this thing, the rates adjust and you don't have...

the interest rate rate. Because fixed income investors got destroyed in 2022. And investors that were exposed to floating rate, that is more credit risk, which actually weirdly held up in 2022, made it out just fine. Yes. But I do think there is something to the fact that

fixed income investors have woken up to the fact that I need to be way more thoughtful about this allocation and maybe have different pieces of my allocation that account for deflation and disinflation and then inflation and then financial crises and all these different things that can impact different aspects of the fixed income market in different ways. This is a good conversation with Fran and Bill. It is a highly complex subject.

And so this is not the type of thing that loans itself to just one conversation. So for advisors that are listening and want to learn more, there is more to be found at VanEck.com. So with no further ado, here is our conversation with Fran Rodalosso. Fran is the head of fixed income ETF portfolio management at VanEck. And Bill Sokol. Bill is the VP and director of product management.

Guys, welcome to the show. Thanks for having us. Thanks. Great to be on today. Before we get into the conversation about CLOI, the ETF that we're going to be talking about, collateralized loan obligation, not exactly a corporate bond or a treasury bond.

I'm assuming a lot of people that are listening to this might not have been around back in 2008 when these buzzwords were there for the wrong reason. What is a collateralized loan obligation? So a CLO or collateralized loan obligation, it's a securitized portfolio of leverage loans. These are often referred to as bank loans or syndicated loans.

And these are loans made to cash flow generating companies. The loans are secured by assets of these borrowers, and they rank senior to other debt of these companies. So senior to things like high yield bonds. And historically, they've had lower levels of losses as a result of that seniority. A CLO typically holds 150 to 300 of these individual loans.

And like any securitization, what happens is that the CLO will issue debt in order to fund the purchase of those loans. So the investors in that debt earn the interest that is being generated by the underlying loans. So interest and principal actually is paid to the debt investors. But this isn't paid pro rata.

it's paid sequentially. So you have different levels of subordination, you have different tranches, you have different credit ratings that reflect the seniority. So you have a AAA tranche that's going to be paid first, paid interest first, and it's the most insulated from losses in the portfolio. You have an equity tranche, which absorbs any default losses first,

before any of the other debt holders and it receives all the excess cash flows after interest payments are made to the debt holders. And between the AAA and the equity, you have AA down to BB typically. And this structure does allow for different levels of risk and return. And they, I should also note, they pay floating rates of interest. So that reflects

the same floating rate nature of the underlying loans. So you're going to get a SOFR plus a fixed spread. And the spread is going to reflect the level of risk you're taking. What is the reason for the floating rates? Why is it floating?

Well, leverage loans are floating rate. It's the nature of the asset class. Typically, it's because these are made or historically, these have been made by banks and banks like holding floating rate assets. And you want to match the assets of the CLO, which in this case is the loans with the liabilities, which is the CLO debt. So you don't have a mismatch.

All right. So pretty straightforward. No, I'm just kidding. That was a lot. We're going to unpack this over the next 30 minutes. So, all right. These are like loans of loans with different tranches. Fran, what exactly are we looking at here? Think of a CLO as a fund. And that fund has an equity investor. Sometimes it's the fund manager. Sometimes it's outside parties.

That represents about 10% of the capitalization of that fund. 90% of the capitalization of that fund comes through the issuance of debt. Those are CLO tranches. They range from AAA typically down to BB. So there's sort of one in each major rating fund.

category. So from an end investor point of view, you can lend money to this CLO structure by choosing the level of risk you want to take. You could lend money at the AAA level, which has a super high degree of subordination underneath it, which receives really most of the first cash flows.

that accrue to that CLO. As I said, a CLO is like a fund. What's being held by that fund are, as Bill said, broadly syndicated loans or bank loans, which are typically sub-investment grade, but it's a large diversified portfolio of loans. And that is where a lot of the protection comes in for investors, that and the subordination of the lower rated debt tranches and of course, equity to the higher rated debt tranches.

So in 2022, when we had the bond bear market, it wasn't really a credit event. It was an interest rate risk event, right? So my guess is because of the floating rate nature of these, CLOs managed that period pretty good then. Yeah. So the floating rate nature certainly helped.

In 2022, 2023, it continues the rate volatility we've seen. And it's the floating rate nature, but also, as I'm sure we'll discuss, you get a spread pickup as well, a very attractive spread over the floating rate. And that also helped with returns.

So you guys timed the launch very well. It was June 2022. As Ben mentioned, we were in a really nasty bond bear market, but that was primarily in treasuries of all things and investment grade bonds. So from 2022 to today, almost a billion dollars in assets has entered. In fact, it was over a billion at one point. But so obviously there was a massive amount of demand for something like this

Why do you think investors are starving for this sort of investment? A couple of reasons. One is they're looking at the returns that they've delivered through bouts of rate volatility. But number two, when you look at even longer term risk and return charts,

CLOs have really high Sharpe ratios. They have better returns than investment grade credit with lower volatility. The leave at the lower rated tranches, you'll have higher returns than US high yield corporates with the low interest rate or zero interest rate duration. They're not correlated to say your ag or other core fixed income instruments. So there's this diversification benefit

as well. So it's a combination of risk, return, diversification. Is one of the downsides then if we have a disinflationary environment or a deflationary environment and other bonds get a little boost because of yields falling, is that where CLOs struggle? What's the downside for these assets? The coupon will go down if the Fed starts cutting rates. That's just the nature of floating rate. But there's no price in that. So it's not really a downside. You're not going to see rate

sensitivity from a price perspective, really these are credit instruments. So the main risk here is that you have a credit event that spreads widened out and you're going to see that reflected in the price, the value of the CLOs. They're much more sensitive, especially as you go down the capital structure, they're much more sensitive to credit. So I want to talk about the packaging of this product because there's been an extraordinary

dis amount. That's not a word. There's been no volatility. If you're looking at the price return of this thing, it is up until the right. The max drawdown is like 3%. So talk to us about the mismatch between like the liquidity that you get in the ETF wrapper versus the underlying portfolio of

within each loan that's in this portfolio. And then I guess in the event that there is a credit event in the economy, would we see this thing gap down 15% or how would the price discovery work? And forgive me for the long rambling question. A few things. Maybe we'll start at the end of that question.

how much CLO prices. Remember, these are debt instruments that are collateralized by those loans. These actually trade more like bonds. They're normal settle, T plus one settle. There's not necessarily a lot of electronic trading. It's a lot of end investor to end investor via trade lists like bid wanted in competition or offer wanted in competition lists. But they also trace their transparent. So the

The CLO tranches that are issued by these structures have a very different dynamic in terms of the liquidity, although levered loans also trade pretty regularly and are quoted. They just have longer settlement cycles. So particularly in the AAA and AA tranches, even down to the single A, there is a lot of liquidity, meaning you can see, you know,

point bid ask spreads, uh, through bouts of volatility. There are typically buyers because there are, uh,

bank treasuries, there are corporate treasuries, there are insurance companies. Japanese banks are a well-known user of particularly the AAA tranches. Same goes with a lot of those institutions for AA tranches. It's as you go further down to say the BBB and BBB tranches where, Michael, to your question, where you might see those 15% drawdowns, that's possible.

And that has happened. And that's where a lot of BBB CLOs, by the way, very few of them have ever defaulted historically, like a very, very small number. So the structures have held up, but the price volatility in response to shifts in the credit market is there. And that's, you know, that further down the cap stack is where you see that type of price volatility. In terms of

the ETFs performance. Maybe Bill, I'll let you speak further to that, but I'll start by saying we haven't seen that much even spread volatility over the last several years, even since this was launched or the other CLO ETFs that are out there. And Bill, maybe you want to talk a little bit more how this ETF would respond to that.

Well, I guess I would just say to Fran's point, the last three years, right, we haven't, we've only seen really tightening spreads with a few blips here and there, including very recently. But of course, you don't have the rate sensitivity. And that's going to be, I mean, that's usually your biggest driver of returns in fixed rate

core bonds. So you don't have that. You have the credit sensitivity, which we haven't seen a lot of lately. But it is why we do think when you are investing in CLOs, you need to have the right strategy. You want to invest broadly across the capital structure. Given that you will have lower liquidity and higher volatility as you move outside of AAAs, you want to have the ability to stabilize

stay nimble to manage risk, but also to find the best opportunities. And we think being very active in your approach and having flexibility that doesn't just look at the rating is the right way to manage those risks. We had an example just several months after we launched the ETF. There was this sort of LDI crisis with the UK pension funds.

And they needed to raise liquidity. They were decent-sized holders of the higher-rated CLO tranches. That's what they sold. They sold AAA, even some AA CLOs, not because they were for sellers. It's because that's where they could get the liquidity from.

And so that was a pretty good example. CLOs did get a lot of attention at that point in time because that's what those funds are selling. But the price volatility did not show up in those higher rated tranches. There were plenty of buyers at that point in time.

You mentioned the spreads. People have been worried for, I guess, a couple months now that we're seeing a slowdown in the economy. The stock market is rolling over. People are becoming worried again. And one of the things people in the finance world keep pointing to is, well, spreads are still pretty darn tight, and they haven't blown out yet.

Does this surprise you at all? And I guess my follow-up would be, is the bond market going to be prescient enough to see a slowdown coming and then spreads will blow out? Or do spreads blow out after the fact that you already see the slowdown is here?

First of all, you're talking to someone who's been in the bond and credit markets for 30 years. So I'm always thinking spreads are too tight. So that's just the nature of being a bond market pessimist. I should have started in equities. It would have changed everything. But yeah, I mean, when you look at fundamentals sort of to a backward looking view on spreads, you could justify them. The question for us has been,

Looking forward, our potential paths for the market, for the economy, for corporate balance sheets are the various risks priced in enough. And I think a lot of people agree there's not a lot of room for error in credit spreads. But on the other hand, you've got base rates that are pretty high levels. So you could look at over 5%.

on investment grade corporates, over 7% yield on even high yield fixed rate corporate bonds, CLOs which are much higher in credit quality overall, coupons are still over 6%, the weighted average yield to worst is still close to 6%. These are still attractive all in yields with a lot of carry that could cushion against

wider spreads, not a 500 basis point blowout in spreads that might come with a surprisingly deep and rapid recession. So we expect that there will be more spread volatility and more rate volatility. We think CLOs are a way of actually going up in quality for people with high yield or levered loan allocations now to help weather some of that.

So as investors talk to you about some of the opportunities, risks in the fund, and they go to your faction like, oh, okay, let me just take a look at what's under the hood. And they look at the top 10 holdings. They say, well, okay, Neuberger Berman Loan Advisor, CLO. And Fred, I see you laughing because it's a bunch of CLOs in here. So what exactly are investors getting exposure to when you really look under the hood?

Well, with each CLO in the ETF portfolio,

underlying that are typically hundreds of individual leverage loans. So ultimately, they're getting the payments from those loans, but with the protection that the CLO structure provides. They're also getting the expertise of the CLO manager. So you mentioned Neuberger Berman. So Neuberger Berman is actively managing that portfolio of that CLO. And in our ETF, they're

They're getting the credit selection of our sub-advisor, which is Pinebridge Investments, to look into the loan portfolio, assess the manager, assess the terms of the CLO to make sure there's value in holding that deal. You mentioned the structure of the CLO. So this is senior to everything else?

So in the event of distress or bankruptcy, this is the slice that gets paid first? Yeah. So there's multiple layers of subordination. There's the underlying loans, which are senior to bonds. So you do have senior secured exposure in the underlying loans.

Those are securitized, and what we hold is the CLO debt. So in addition to the underlying strength of the collateral, you have the subordination that's built into the structure of the CLO. So if you're buying a AAA or a AA, for example, you have the subordination of all the

tranches underneath you, as well as the first loss equity tranche. In the event of a real recession, what would you expect losses to look like? But also, drawdowns can be divorced from actual losses, no? Investors could overreact. In a recession or a big credit event, we would expect to see spread widening and some level of drawdown. And what that level is will depend on the severity of

of spread widening, we don't expect to see defaults. In CLOI, which is our investment grade CLOs, investment grade tranches, just from a mathematical perspective, when you look at the amount of subordination, even below BBB, it's very difficult to have enough defaults in a loan portfolio where you're going to see impairment of even the BBB.

And when I say very difficult, we're talking multiples of the historical average of leverage loan defaults. And you need to see that over typically five to seven years. So it's just something that doesn't happen. So default risk is not the primary risk when you're investing in investment grade CLOs.

It's spread risk. It's the mark to market that you might experience when spreads widen. All right. So I don't want to put words in your mouth, but I feel like that particular risk of spreads widening, that happens in a recession, of course, no? That is your primary risk. The depth of losses will vary up and down the cap stack, right? So the high yield tranche of BBs, maybe

start trading down into the mid to low 80s in terms of cents on the dollar, the higher rated AAA down the single A, you might see 5% drawdowns, maybe more in an extreme scenario. But Michael, you already made the point. Those permanent losses, which would come from the CLO tranches themselves defaulting,

There's a historical record going back 30 years. So these existed during the global financial crisis. In fact, they've existed since the early or mid-90s. The structures were actually less robust than they are today in terms of having a little lower levels of subordination, not quite as strict on the diversification mandates to get the ratings. There was virtually no

that suffered permanent losses in the five years, like 2008 to 2013. We have a chart in one of our books of losses, meaning default losses among CLO tranches. And it's basically a flat line at zero. Yes, a handful of double B tranches and Bs.

And a very, very small handful of BBB tranches did default. But those were like on a market basis, it was negligible permanent loss. But the volatility can be high. These correlate with the loan market and the high yield market. They don't correlate with the treasury market. This is a good transition into your investment process. So I'm curious, do you have a specific part of the CLO market that you focus on? Do you only invest in high quality bonds? Do you have credit standards or is it more...

Due to the environment that you pick, what is looking the best because of the spreads or because of the economy? Do you have a specific area you focus on? Well, we have two ETFs. One focuses just on investment grade, so AAA to BBB CLO tranches. The other invests in lower-rated mezzanine, which is basically everything below AAA, but

So it's going to give you a higher yield with more volatility, of course, in the event that you do see a recessionary environment. But how those CLOs are selected is actually by Pinebridge Investments. So they're the sub-advisor on the ETFs.

They have decades of experience in this market. They've managed similar strategies for their institutional clients. As far as the process, Fran, do you want to walk through that? Sure. There's both a top-down and a bottom-up element. So certainly, macro views and a macro call.

would lead to relative positioning and say that the top of the stack, the AAA versus whether or not there's enough value say in the all investment grade one to be going more heavily into the BBB tranches. There's also a big bottom up component. Michael, you asked about some of the risks, like the managers themselves can be risks. There are about 200 managers in the space overall.

And, you know, there are maybe 52 that are represented, I think was the last number in CLOI today. So they're not going to, there are some managers that Pinebridge will stay away from. They don't believe they're good stewards of that portfolio. So there's a tiering of managers. That's one risk. But other sort of bottom-up analysis, they literally look into the underlying loans for all of these structures. And

Uh, you know, it takes a lot of systems and a lot of analysts, uh, and that's, you know, why we hired a sub-advisor for this product because they had all of this infrastructure. Uh, you can anticipate, you know, where the equity tranche might start, uh, uh, suffering, you know, fairly significant first loss absorption and, uh, or where a CLO might start breaching, uh, some of the diversification mandates that are in, uh,

the documentation to begin with. I mean, these things, as Bill said, 150 to 350, some structures have 450 loans in them. You won't see individual issuer concentrations typically go above 2%. No industry is gonna be more than 10%. So there's all sorts of enforced levels of diversification.

structures that breach these or that have too much exposure to triple C rated loans. Those might be things that the sub-advisor will avoid. Or maybe if the AAA tranche is trading at a significant discount to par,

and a breach is going to force acceleration of payments to the AAA tranche, that might actually be an opportunity. So it's obviously a very nuanced market. I don't want to go too much deeper than that. But needless to say, there's a process that starts with manager assessment,

it goes into looking at each individual CLO or deal from documentation to what's in the portfolio. Then there's a top-down portfolio construction. Is it time for risk off or risk on? In CLOI, by the way, even risk on, we're never going to be really below at least 40% in the AAA and AA tranches combined to always maintain that liquidity portion of the portfolio. So not to give you a compliance question,

people a heart attack. But we've got a lot of trading data and trading history from the high yield ETFs. They were around in the GFC and, of course, afterwards. So they lost almost 50% on a price basis, just in terms of the price drawdown. In 2020, during the sharp sell-off, these things were down over 20%.

Would you expect CLOI to trade in line with that? Does it have that sort of potential price volatility in a nasty global event? Part of it is going to depend how it's allocated at that time. And that's why we have a broad strategy with that top-down strategy.

lens, right, in terms of allocating the portfolio. So if it's mostly in AAA or AAA AA, I would not expect that. And that's where the active management comes in, I think, with CLOB, which is the lower rated strategy, you could have returns, certainly closer in line with what you see in high yield or leverage loans, it's probably

The ETFs didn't exist in 2020, but there's been a broad index that's been live since about 2020. The sell-off, at least in as much as it's reflected in the index performance during 2020, the broad CLO index behaved more like investment-grade corporates, which was still a very significant drawdown for that brief period. What is the case for CLOs in somebody's portfolio?

What does this compete with or replace? And why would you invest in this versus something else? The nice thing about CLOs is that they have a full capital structure. So first, you have to determine what level of risk you want to take. But if you look at CLOs broadly, they've had the best risk adjusted return over the last decade. So

You know, any exposure would have helped in a fixed income portfolio over the last decade. And when I say the best performing, I'm talking among other fixed income asset classes. So if you're looking at investment grade tranches, you know, we think that makes a lot of sense in an investment grade portfolio. So you would probably fund that with, you know, a core bond from a core bond fund or investment grade corporates.

for treasuries. If you're looking lower in the capital structure of a CLO, that can be a really nice complement to high yield. So what are you getting? You're getting higher spreads versus bonds and loans with the same rating. You're getting safety. I mean, adding investment-grade CLOs, you're getting a better credit quality with very low default risk.

certainly versus investment-grade corporates. And you're getting diversification. That's both from the underlying credit exposure, but also the floating rate nature of CLOs versus a typically fixed rate exposure for core bonds. We had a lot of investors who wrote to us during the bond bear market and said, hey, listen, I thought inflation was going to come because the government was spending trillions of dollars, and I put my money to tips, and I still got killed.

And so I think a lot of people said, I guess the only alternative is for that environment is T-bills or something that's very short term and that it's going to get the pickup. So I guess you could say in a lot of ways, CLOs are kind of an answer to that, right? Where in that type of environment, a rising rate environment or a higher inflationary environment, CLOs are probably going to do better than your typical bonds. Is that fair? Yes, that would be. That's not the only case. This is a credit.

And so it isn't just about rate protection, but in that environment of rising rates, particularly since a lot of rising rate environments are not necessarily negative credit environments, that would make CLOs a very attractive choice for

But they are also like take today's environment where people are expecting at least the base rate to come down another 50, 75 basis points this year when the coupons on CLOs might come down then in unison with that if credit spreads remained roughly where they are. But you're getting like for AA rated CLO tranche, you're picking up about 95 basis points in spread versus a AA corporate rate.

So that spread pickup, it's been there all along and it does vary, but that is another thing that will draw investors to CLOs and why the CLO ETFs have grown a lot in the last several years is

is not because this is some new asset class. It's an asset class that's been around for several decades, but there are a whole class of investors or several classes of investors that just didn't have access to them. Starting in 22 and going to almost a billion dollars in such a short period of time is super impressive. It speaks to, listen, the proof is in the pudding, at least so far. Do you have any idea, I know it's tough with ETFs, but

Do you have a sense of who is investing in these things? Are these institutional investors? Are these RIAs? I would assume that this is probably less a retail-driven product and more an intermediary or institutional product. In our funds, we're seeing most of the inflows coming from advisors, typically RIAs.

They have been big adopters of CLO ETFs. I would say the other channel where this has found success is with insurance companies. So insurance companies have historically been very big investors in CLOs.

But the ETFs provide them the same exposure that they've been getting maybe through separate accounts with institutional managers, but with the liquidity. So often they might use the ETF alongside individual holdings of CLOs. Fran, do you find this to be a more difficult investment to explain to people that are inquiring? What's your most commonly asked question, I guess?

To question number one, yes. The learning curve is long and steep. So it's usually not a one meeting or two meeting type sales process. Our sales team has spent a lot of time trying to understand what they're talking to their clients about, but that's super important. And we do like to focus on some of the risk factors.

risk aspects as well. So yeah, it definitely takes a lot of explanation. The very first question that almost always comes up for someone new to the asset class is, isn't this what blew up markets in 2008 and 2009?

And we have a pretty chart that says, no, those were other types of collateralized debt obligations in the subprime mortgage sector and global CDOs that were a kitchen sink full of everything. And these structures actually held up quite well.

You didn't ask this directly, but yes, they did experience extreme price volatility back then, of course. But those permanent losses via defaults at tranches were very few and far between. So it's never a loss unless you sell. That's what we're trying. I'm only teasing.

But I always like to say that the easiest thing to sell investors is yield. And you mentioned that you have the spread over these other parts of the bond market at various credit ratings. And I think that's the easy sell is you can get a bump in yield by investing in these products, correct? Yeah.

Yeah, I think it's a bump in yield and you're not taking on additional risk. It's the quality that you're getting along with that higher yield. So what are you giving up? Because there's got to be something that you're, there's got to be a give and take. Well, I think there's a few things. I mean, one, there's just the complexity, right? I mean, it's understanding, right? Investing in something that's complex. All right. So what you're giving up is like a little bit of like, what exactly am I investing in?

Well, I mean, there's the complexity that goes along with it. And of course, like the volatility, right? We've talked about the volatility, the spread risk. That's something that needs to be well understood, I think. And you're giving up duration. Like for some investors, they want the duration as sort of one of their risk-off, risk management tools. And that's something...

They don't serve that purpose. In fact, for a lot of our investors, they've seen it as a great complement to a high-quality, longer-duration allocation. And so it's sort of a balance.

That makes sense. All right. So for advisors that are listening, they're like, all right, I'm intrigued, but I definitely need to learn more because that's a lot. Where do we send them? I assume that you guys talk to advisors all day. Is that right? Yeah, we do. And we've been having a lot of meetings on CLOs over the last three years. And, you know, I would encourage them to go to our website, bandmech.com. We've been doing a lot of educational content over the last few years. We have blogs, white papers,

We do webinars a lot because there's a lot of education needed, and I think that's going to continue. All right. Well, Bill and Fran, we appreciate the time today. Joining us on a Friday, no less. Thank you, guys. Enjoy your weekend. You too. Thank you. Thank you both very much. Thank you to Fran and Bill. Remember to check out vanek.com for more. Email us, animalspirits, at acompoundnews.com.