A "Safe" 6% Yield: The Case for Investment Grade CLOs
32:41 Share

Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today's episode 423. It's titled, A Safe 6% Yield? The Case for Investment-Grade CLOs.

About five years ago in episode 205, we discussed a rather obscure asset class that goes by multiple names. The names include leveraged loans, syndicated bank loans, floating rate loans, or senior loans. These are loans issued by banks to non-investment grade companies, and those loans are then sold or syndicated into the market. Buying and selling of these loans is not as smooth as it is to purchase a stock.

The settlement time for a transaction to go through can be upwards of 20 days compared to two days for most securities. Leveraged loans are called senior loans because they have to be paid before any other debt that the company may have on its balance sheet. Another advantage of these leveraged loans is their variable rate loans. They pay an interest rate that is tied to short-term interest rates.

They pay more. There's a spread above the short-term base rate that is used to calculate the yield. But because it's variable rate, there is no interest rate risk. These loans don't go down in price when interest rates increase.

Leveraged loans do have risk. There's default risk because, again, these are non-investment grade. These are not the most stellar credits. And so it's often helpful to have an active manager selecting which of these bank loans to purchase.

Another risk with leveraged loans is not just defaults, but when the risk of defaults is increasing, the price of these loans can fall, and that can lead to unrealized losses on the exposure to bank loans.

Back in episode 205 and again in episode 305, we discussed the largest buyer of leveraged loans. These are CLO managers. CLO stands for Collateralized Loan Obligation. We'll go into more detail in this episode how CLOs work.

Four years ago, there weren't many vehicles to invest in CLOs. There were a few closed-end funds, but there definitely were not ETFs. Now there are a number of lower-fee ETFs that allow investors to get exposure to CLOs and some attractive characteristics of CLOs that we'll discuss in this episode. First, though, let's take a look at the leveraged loan market overall.

In the U.S., total corporate business debt is around $12.6 trillion, according to the Federal Reserve. About $2 trillion of that $12 trillion is bank lending, and this would typically be lines of credit that a company would access through the bank or could be some other type of loan, could be for an investment-grade company, but these are loans that are not sold or syndicated. The leverage loan component over

Overall in the U.S. is about $1.3 trillion. And then the other element would be bonds, which is debt issued directly by the company, as well as commercial paper, which is very short-term debt issued by the company. So bonds and commercial paper, about $7.5 trillion. Direct bank landings, $2 trillion. And then there's $1.3 trillion of leveraged loans.

The overall CLO market is about a trillion dollars, but again, CLOs own leveraged loans, but in a very unique structure. I've been investing in leveraged loans for almost 20 years. We first introduced them to our institutional clients back in 2006. I was the chief portfolio strategist for

For about, I don't know if we had a billion dollars under management then for that particular product, but we had discretion to make asset allocation changes for these institutional clients, many of which were endowments and foundations.

In working with our research group, we decided to add leverage loans to some of our clients' portfolios. And we used the VirtuSykes Floating Rate Income Fund.

This is the same fund that we used in our adaptive model portfolio examples of money for the rest of us plus from 2016 to where we exited leveraged loans in March 2020. And then we've since added back some exposure to leveraged loans through the double-line flexible income fund.

It makes up about 5% of our overall allocation in the adaptive models, and that fund itself has 8% in leveraged loans and 19% in CLOs.

Leveraged loans were relatively new to me in June 2006. We sold the PIMCO Diversified Income Fund at the time to help fund the new allocation. And what we liked about them were some of the aspects I've just discussed. There was minimal interest rate risk because they were variable rate and they were yielding close to 7% because at the time, short-term interest rates in 2006 were 5%.

The other benefit of leveraged loans is typically the recovery rate in the case of default has been higher than for traditional high-yield bonds. Typically, high-yield bonds will recover about 40% of the amount that's owed when there's a default, whereas leveraged loans have been closer to 60% to 70%, although there's some question given the underwriting standards

have lessened for leveraged loans in the last number of years, whether recovery rates will continue to be as high as 60% to 70%. It could be lower than that.

We mentioned how bank loans hold a more senior position in the company's capital structure, allowing for higher recovery rates. And we implemented the position. We held it for about a year and a half until February 2008. And we saw the price of these leveraged loans fall. The Sykes Floating Rate Income Fund was not doing as well as the bond market.

As someone that was managing against a benchmark, trying to outperform a benchmark for our clients, I found that incredibly frustrating because I didn't realize the extent that leveraged loan prices could fall as their spreads widened. I was aware of that for high-yield bonds, but we just couldn't get as much information on bank loans.

At the same time, the Federal Reserve had started reducing interest rates. Short-term interest rates had fallen to 3% by February 2008. And so these loans effectively had about a 40% cut in their base rate.

This was just as the great financial crisis was starting. At least the symptoms were there, but things were really starting to fall apart. And seeing an element of our portfolio just not acting right, it didn't feel right.

At the time, I wrote to our clients, we are adverse to holding onto an investment if we no longer believe the potential reward justifies the risk. There are many ways to define risk, but one element is uncertainty. The dramatic widening of bank loan credit spreads coupled with their unprecedented volatility in the past six months testifies to the extreme uncertainty currently surrounding the asset category.

I probably would have reworded how I said that if I was writing it today. I distinguish between what is risk and uncertainty. Risk is something where we know the probabilities, where we can determine the potential outcomes and then assess the likelihood of a particular outcome happening. Uncertainty is where we don't know. We don't know what the potential outcomes are. And as a result, we don't know the probabilities.

In the case of bank loans, it was uncertainty just because we weren't as familiar with the asset class. And so we sold. I wrote, we decided to exercise our investment flexibility and exit bank loans until there is greater visibility in terms of defaults and spread levels. I continued, some of the greatest return opportunities for non-investment grade issues are when defaults and spreads have peaked. And some of the worst are when defaults are increasing and spreads are widening. So we exited defaults.

The Sykes Fund, it went on to lose over 20% in 2008. And then we finally started adding non-investment grade bonds again in late December of 2008 after spreads had increased to close to 20%. It's 15 years later. Now we have the Federal Reserve raising interest rates to combat inflation. Yields on leveraged loans are over 9%.

The spread or incremental yield over short-term interest rates is somewhere between 4% to 4.7%, depending on the index you use. We have recession risk increasing, and default rates are starting to increase because interest rates are 9%. It's making it more difficult for these companies to service the debt.

About a year ago, I added a leveraged loan fund to my portfolio, the BlackRock Debt Strategies Fund, DSU. This is a closed-end fund. It has about 80% in leveraged loans. I added it at the time knowing recession risk could increase, but it hadn't happened yet. But I've decided to hold on to it, and it's done fine. It's a smaller position. It's returned about 7% since I added it compared to the overall bond market, which has declined 5%.

but I added it because it's an active manager. But there is risk there if spreads on leveraged loans increase and prices fall. It's been a volatile fund because it uses leverage, but I'm a long-term holder of it, and it's done fine. I've also taken the other side of leveraged loans. I have bought puts.

on the Invesco Senior Loan ETF, BKLN. I bought that in March 2019 with the idea that if we hit a recession, the loans would sell off as well as the ETF. We had a pandemic instead and the ETF did plummet, but I didn't sell. I didn't sell until July 2020 and severely lowered my profit. In fact, part of that just broke even because the Federal Reserve was so active in buying up corporate bonds, they

that that put a floor on leveraged loans, and they recovered.

Now, if you look at the long-term performance of leveraged loans, the Sykes Floating Rate Income Fund from June 2006 through yesterday has returned 4% annualized. That's through the great financial crisis, as well as an extended period of very low interest rates with base rates close to zero, and the pandemic and the recovery, and now a potential recession, a 4% annualized return.

That compares to 3% annualized for the iShares Aggregate Bond Market ETF, so the overall bond market. Over the past decade, the Invesco Senior Loan ETF, BKLN, has returned 2.5% annualized compared to 1% for the iShares Aggregate Bond Market ETF. If we look at

current expectations for investing, Sykes actually offers an ETF now. It's the Virtus.Sykes Senior Loan ETF. It has an expense ratio of 0.57%. It is actively managed, so you're getting the benefit of the credit research. Sykes has generally always been a more conservative leveraged loan manager. I

That's why we use them at my former firm, FEG. It's why we've used them in our model portfolio examples. It's why I've owned the fund personally. I also sold the fund in March 2020 as we exited it in our models.

The ETF right now has an 8.1% SEC, which is attractive. One of the things that's going on in the leveraged loan space is the base rate used has traditionally been LIBOR, which stands for the London Interbank Offered Rate.

Most leveraged loans in the U.S., about 78%, are still tied to LIBOR. But LIBOR is set to go away at the end of June because LIBOR was set based on what about a dozen banks were willing to borrow money or pay to borrow money from each other. And it turns out those banks started rigging that rate. There's been over $8 billion of fines.

Regulators have basically said LIBOR is no more. One rate that is being used that the Fed recommends is the secure overnight financing rate, SOFR. Right now, that's around 4.55%.

So we have a transition in terms of the base rate because of this LIBOR scandal. But as we think about leveraged loans, the benefit is they are variable rate. So you have the interest rate protection, but the main risk is default and prices falling, particularly heading into a recession, which is why now is a particularly dangerous time to be investing in leveraged loans. Although I

have exposure through one closed-end fund. Before we continue, let me pause and share some words from this week's sponsors. Before we continue, let me pause and share some words from one of this week's sponsors, NetSuite. What does the future hold for your business? Ask nine experts and you'll get 10 answers. Bull market, bear market, rates will rise or fall, inflation, up or down. Be great if we had a crystal ball, but we don't.

Until then, over 38,000 businesses have future-proofed their business with NetSuite by Oracle, the number one cloud ERP, bringing accounting, financial management, inventory, HR into one fluid platform. With one unified business management suite, there's one source of truth, giving you the visibility and control you need to make quick decisions. With real-time insights and forecasting, you're peering into the future with actionable data. When

When you're closing the books in days, not weeks, you're spending less time looking backwards and more time on what's next. I know as our business grows, we'll certainly consider using NetSuite by Oracle. Now, whether your company is earning millions or even hundreds of millions, NetSuite helps you respond to immediate challenges and seize your biggest opportunities. Speaking of opportunity, download the CFO's Guide to AI and Machine Learning at netsuite.com slash david. The guide is free to you at netsuite.com.

Thank you.

and career advancement. Plus, you'll have the opportunity to participate in an international consulting project abroad with a global client. You'll get to choose from a variety of electives to customize your curriculum based on your interests and career goals. And enjoy the access only Georgetown provides in D.C. with connections to industry experts, global leaders, and influential institutions.

It's time to expand your understanding of how globalization shapes both global and local business strategy. Ready to build your legacy as a business leader? Earn Georgetown's Executive MBA. Explore the program at msb.georgetown.edu slash emba-podcast.

A more interesting way to invest in leveraged loans is through collateralized loan obligations, CLOs. Let's explore how they work. These are examples of what are known as structured products, in that there is a complicated structure that underlines a CLO. They were first introduced in the late 1980s.

It starts with a CLO manager that goes out and buys up a portfolio of leveraged bank loans. And then it breaks up that portfolio into tranches. And those tranches are then sold to investors. And the tranches are by different credit ratings. So you have a AAA tranche, you have a AA tranche.

A single A, a triple B tranche, ultimately down to more speculative tranches. And at the bottom, you have the equity component. How do you get a triple A rated tranche that's made up of leveraged loans that, as we said, are non-investment grade? You do it through what's known as over-collateralization.

The CLO manager buys more leveraged loans that are generating interest income and principal payments, and there's more leveraged loans than the actual value of the tranches that are sold to investors. Then what happens is as the interest income comes in, it first goes to the highest rated tranche, and there are certain tests that need to be made.

There is an over-collateralization test to make sure that there's that margin of safety or buffer there. And if there isn't enough buffer in the AAA tranche, then no one in the lower tranches gets paid. There's also an interest coverage ratio. There

There needs to be enough interest income plus a buffer to meet the promised interest expense for that given tranche. And so we have what is known as a waterfall. The cash flow first goes to the highest tranches, the AAA tranche. Make sure that the over collateralized coverage test is met. Make sure the investment coverage test is met.

And if so, then those tranche investors get paid and then it goes down to the next tranche. Those tests are done. There's enough cash flow. It keeps going down. And at the bottom, we have the equity layer, which is the most risky but potentially highest yielding, highest returning layer of a CLO.

The CLOs typically have well over 100 different leveraged loans. They're diversified by industry, and it's the responsibility for the CLO manager to service the CLO and buy the leveraged loans and package them into these CLOs. Now, the different tranches are often rated by outside rating agencies such as S&P, and they look

look at the amount of over-collateralization, the interest coverage ratios, and we'll assign a rating to the particular tranche of the CLO. Some of the biggest CLO managers are Carlyle Group, Blackstone, Golub Capital, and investors in CLOs in the senior tranches, the AAA and the AA, it's banks, it could be institutional asset managers, insurance companies, pension funds, and now because there are ETFs,

that focus in the AAA, double A tranches. We as investors, individual investors can invest in them for the first time. Back in episode 205, four or five years ago, it was not possible.

Now, there are also institutional managers that invest in what are known as the mezzanine tranches, which would be single A, triple B, double B. And there's some ETFs that I'll share that invest in that. And then in the equity tranche, this is the highest risk. You have hedge funds. You do have some pension funds and endowments investing in them. It's a broad array. And as individual investors, we can invest in those also, primarily through some closed-end funds that have been around for a number of years.

The biggest risk with the CLOs is credit risk, just because there's risk with leveraged loans due to credit risk. There's also that type of risk with the CLOs.

Here's what I find most fascinating about it. Because of the over-collateralization, these coverage ratios, the interest coverage ratios, this is from S&P, they rate these tranches. And they've rated 12,200 tranches over the past decade or so. And there's only been five defaults out of 12,000.

And within the AAA, AA, single A, and BBB, there has been no defaults at all. The default rates on CLOs is much lower than traditional non-investment grade bonds and credits. For example, if we look at the global financial crisis, S&P reports the three-year speculative grade corporate default rate was 15% as of September 2011.

The CLO default rate over that same period was 2.3%. If we look at what happened during the credit stress of 2020 when the pandemic hit, the corporate 36-month trailing speculative grade default rate peaked in November 2020 at 8.8% compared to the 36-month trailing speculative grade CLO default rate of 1.1%.

That 1.1% includes the lowest credit quality tranches. CLOs have been battle-tested through the great financial crisis, through the period of very low interest rates, through the pandemic, and defaults in those higher tiers have been non-existent.

S&P also did a forward-looking stress test. They looked at what would happen today if we had a great financial crisis scenario. And they did a number of different versions of this stress test. And within the AAA, the AA, and the AA, they don't see any defaults or non-performing loans.

The non-performing percentage in the BBB is expected to be 2%, BBB much higher. So in a severe situation, 43% of the BBB tranche could be non-performing and upwards of 87% in the single B tranche. That's enough to scare me away from the lower tranches of these CLOs.

Partly because I'm not a CLO expert, and I'm definitely not comfortable with the equity tranche. But the higher tranches, because the yields are attractive, particularly relative to other cash offerings, and clearly this isn't cash, it does have credit risk, it is potentially very attractive because you get the interest rate protection that doesn't fall when interest rates rise, but you also get the over-collateralization.

Now, just because the higher tier tranches haven't had any defaults doesn't mean they can't be volatile. All CLOs can be volatile if the spread on leveraged loans widens out as investors worry about default risk. The price of CLOs, even the highest tier CLOs, can fall just like leveraged loans can. So these are not cash-like in that the prices are stable.

We saw the AAA tranche CLOs, for example, fall 3% at one point in 2022. And if your cash savings fell 3%, that might cause some concern. So there is risk there, pricing risk, volatility, even though there haven't been defaults in the higher tier CLOs.

Now, there are some other risks with CLOs. There's prepayment risk. An underlying borrower in the leveraged loan space could decide to prepay their borrowings. That prepayment flows through the CLO structure, and then the CLO manager has to find a replacement that gets spread out in the various tranches.

Given the low default rates in CLOs, insurance companies have been more and more interested in them, particularly insurance companies that have partnered with large private capital managers such as Blackstone, Apollo, KKR. Those companies are partnering with insurance companies and selling them CLOs. In some cases, they're actually buying insurance companies, whereas more conservative insurance

Insurers like MetLife and Prudential have steered away from CLOs to some extent. Insurance companies, and they're required to reserve some capital, cash or short-term investments against various assets on their balance sheet. When, for example, an insurance company owns a non-investment grade bond, they need to keep some cash in reserve.

in case there's default because the insurance company needs to be able to meet their commitments to annuitants and others that have bought insurance. Turns out the amount that needs to be reserved for owning a CLO is less than if you own the leverage loan directly. And that has caused some controversy because the

The more aggressive insurers, partnering with private capital managers, have been willing to go into CLOs, and the more conservative insurers haven't been. And they're saying, how come the amount that has to be reserved for owning a CLO is less than if one owned all the same bonds but outside the CLO structure? And so the National Association of Insurance Commissioners are having lengthy discussions on it. They've taken public testimony, and we'll see where it stands.

It's an interesting phenomena because insurers are becoming more interested in these CLO structures also.

How do we invest then? Well, I've mentioned that I own in my portfolio as well as in the adaptive model portfolio examples of money for the rest of us plus the Double Line Flexible Income Fund has 19% in CLOs. The ticker is D-F-E-L-X. But there's also pure play. The original CLO ETF was the Janus AAA ETF.

CLO ETF. Its ticker is JAAA. Its SEC yield as of the end of January was 5.5%. Based on the yields of similar ETFs, that dividend yield is probably close to 6% right now. This ETF started in 2017.

2020, back in October 2020. And since then, it's returned about 1.9% annualized. And again, we've had a situation where most of that time, for much of the time, rates were very, very low. Again, forward-looking, the yield is close to 6%. One of the things with ETFs that I have worried about in the past is just price dislocations because an ETF, it

Its price can separate from its net asset value. What's the value of the underlying assets? And it can trade at a premium or discount in the same way a closed-end fund does. But with an ETF, there are market makers that are willing to step in and keep that discount or premium narrow.

In a couple of weeks, we're going to release an interview with Christoph Gleitsch of Harbor Capital, and we go into a fairly detailed discussion on the role of market makers with ETFs as well as authorized participants. So I won't go into that in much depth here, but generally speaking, the premium discount for JAAA has been generally between a premium, a slight premium of less than $1,000 a year,

less than 0.25% most of the time. The biggest premium was 0.75%, and the biggest discount was about negative 0.4%.

Another AAA CLO ETF is BlackRock AAA CLO ETF. Ticker is CLOA. This just came out in January 2023. It has an SEC yield of 5.96%. So very new, but if we consider

the iShares Treasury Floating Rate Bond ETF, TFLO, that has an SEC yield of 4.96%. By investing in a AAA CLO ETF, we can bump up that yield by almost 1%. Granted, it's a much more complicated structure. With the over-collateralization, it is structural finance. As

as opposed to just buying an ETF that's investing in floating rate U.S. government bonds. But the additional yield for the credit risk, the structure risk, is around 1% right now, so close to 6%.

Another option is the VanEck CLO ETF that also invests in the investment-grade tranches of collateralized loan obligations. Its expense ratio is 0.4%, so a little higher compared to 0.2% for the BlackRock ETF and JAAA. The Janus ETF has an expense ratio of 0.22%. The

It's a big fund. The Janus Fund has been around a couple of years, $2.4 billion in assets, whereas the BlackRock is fairly new, $20 million in assets. And the VanEck Fund came out last year, it's around $50 million in assets.

Janus also has an ETF that invests in the lower tranches, leveraged loan tranches of CLOs. It's the Janus BBB CLO ETF. The ticker is JBB. Its SEC yield through the end of January is 7.4%. So as of today, it would probably be over 8%. Expense ratio is 0.5%, about $80 million in assets.

But we need to recognize these lower tranches, there's much more volatility. During 2022, this ETF sold off about 9%. And since inception, it started January 11, 2022. Its annualized returns since inception is negative, negative 2.5%. Year-to-date, it's positive, but the lower tranche CLOs will be more volatile. And so this remains to be seen. I prefer the AAA tranche.

I'll take the 6% yield rather than stretch for the 8% due to the volatility. But we can also look at the equity tranches. Eagle Point Credit Company, ECC, is a closed-end fund that has been around for over five years and invests in the equity tranche of CLOs. Its five-year annualized return is 7%.

My biggest concern with this is it's selling at a 21%, 22% premium to its net asset value. It has a distribution rate of 15% because it has around 30% leverage. So it's a leveraged play in CLO equities, the highest risk tranche of CLOs. It's only returned 7% annualized over the past five years. Another option is...

So investing, 3%.

through a fairly expensive closed-end fund, using leverage has generated an NAV return annualized over the past decade of 6.5%. In my mind, it's just not worth it. I mean, the distribution rate's over 15% right now, but you're going to get the volatility from the leverage. And in today's environment, where the risk of recession is higher, I'll stick to the AAA tranches. In fact, I'm looking very closely at adding that black rock

AAA CLO ETF, CLOA, to my portfolio. Now, there's also ways to invest in bank loans. Obviously, I mentioned the Virtue Sykes Floating Rate Bond ETF. That ticker is SEIX. And there's also the Invesco Senior Loan ETF, BKLN. 6% yield. Is it a safe yield?

It has been. And if we look at forecast by S&P doing stress test, there hasn't been any defaults in that tranche nor expected to be. But it is not a simple investment. And so with any investment, you need to be able to explain and understand it before you invest. And that's one reason we've done this episode. I've spent a number of years looking at bank loan CLOs. I'm finally getting comfortable

to invest in CLOs directly through an ETF, and now there's products to do it. And that's good news. That's episode 423. Thanks for listening.

I have thoroughly enjoyed teaching you about investing on this podcast for almost nine years now. But some topics are just better explained in writing or with a chart. That's why we have a weekly email newsletter, the Insider's Guide. In that newsletter, I share charts, graphs, and other materials that can help you better understand investing. It's some of the most important writing I do each week.

I spend a couple hours on that newsletter each Wednesday morning as I try to share something that will be helpful to you. If you're not on the email list, please subscribe. Go to moneyfortherestofus.com to subscribe to the free Insider's Guide weekly email newsletter.

Everything I've shared with you in this episode has been for general education. I've not considered your specific risk situation. I've not provided investment advice. This is simply general education on money, investing, and the economy. Have a great week.