CLOs: More yield and flexibility than corporate bonds

Doug Charleston, Co-Head ABS at TwentyFour Asset Management, explains why he believes European collateralised loan obligations (CLOs) have one of the most attractive risk-return profiles across global fixed income.

In my first article I highlighted the numerous potential benefits of European asset-backed securities (ABS), the most significant of which is that ABS transactions tend to offer higher yields for a given rating than more mainstream markets such as government and corporate bonds.

Collateralised loan obligations, or CLOs, account for some €240bn of the €525bn public European ABS market,¹ so it is worth exploring this asset class in more detail.

The key features of a typical CLO

CLOs differ from other ABS in a few important ways. For one thing, CLOs are backed by leveraged loans, which are loans that have been made to companies, rather than the consumer loans that act as collateral in consumer ABS products such as residential mortgage-backed securities (RMBS) and Auto ABS. For another, most types of ABS typically invest in assets from a single geography.

Another key difference is that CLOs are actively managed by an asset manager. The CLO manager will select a large number of loans from companies of different sizes, geographies and industries to build a diverse portfolio of corporate loans. The CLO manager can then acquire or dispose of loans during the life of the CLO in an effort to optimise returns, but when they do so they will normally be subject to several limitations regarding the asset type, quality and underlying features so as to retain the overall profile of the CLO.

This portfolio of underlying loans will be placed into a special purpose vehicle (SPV) which houses the assets and distributes interest and principal to bondholders. The SPV also provides investors in the CLO with complete transparency; they can see the exact details of every company in the portfolio, from its credit rating and management to the specific terms of the loan.

Like other forms of ABS, the bonds issued by a CLO are structured into layers, known as tranches, which typically carry different credit ratings, yield profiles and investor protections based on their position in the capital structure.

The potential benefits of European CLOs

Investors who include CLOs in their portfolio can benefit from several unique characteristics of the asset class.

First, the floating rate nature of CLO tranches reduces an investor’s exposure to short-term interest rate risk, effectively a hedge against inflation. Moreover, CLO bondholders are also protected from the consequences of rate cuts as Euribor (the floating rate over which investors are paid a spread) is typically floored at 0%.

Second, the specialism of CLOs as an asset class means they typically offer higher yields than similarly rated corporate bond markets. For example, the euro yield on AAA CLO bonds is currently around 3.84%, compared to around 3.41% for the European investment grade corporate bond index, whose average rating is only BBB+. For BBB CLOs, the yield is currently around 6.06% versus around 5.54% for the European high yield bond index, whose average rating is just BB-. ²

Third, investors holding CLOs can obtain a portfolio diversification benefit, with the asset class normally exhibiting low correlations to investment grade corporate bonds and equities, as well as a historically negative correlation to government bonds such as US Treasuries.

Finally – but perhaps most importantly – we find that CLOs can offer far greater flexibility than regular corporate bonds, particularly when investors are looking to boost portfolio yield. In high yield bonds for example, an investor looking for more yield would normally have to buy lower rated bonds, which might mean taking exposure to a new company where the investor may not like the credit story. By contrast, all tranches of bonds in a CLO are backed by the same pool of loans, with the same performance data available and the same CLO manager – if you like the BBB bonds of a CLO, our experience tells us you are likely to find buying the more junior B notes more comfortable than making the same move down the credit spectrum in high yield corporate bonds.

Given the yield premium available in European CLOs, added to what we see as investor-friendly structural features, we continue to believe the asset class has one of the strongest risk-return profiles across global fixed income.