2023-09-20 09:38:46 ET
Summary
- Collateralized loan obligations, or CLOs, offer investors good growing dividends and low interest rate risk.
- Their performance since inception has been outstanding, if somewhat short.
- A quick look at 3 CLO ETFs follows.
Summary
Collateralized loan obligations, or CLOs, offer investors strong dividends, low credit risk, and almost no interest rate risk. CLOs currently yield more than comparable fixed income securities across credit ratings, asset classes, and maturities, too. CLO yields would almost certainly decrease if the Fed cuts rates next year, as the market expects , but spreads are wide enough that these seem likely to remain attractive. In my opinion, and under current conditions, at least.
Investors looking to capitalize on strong CLO yields have a variety of ETFs at their disposal. Three stand out.
The Janus Henderson AAA CLO ETF ( JAAA ), which focuses on AAA-rated CLO tranches. JAAA has negligible credit and interest rate risk, sports a 6.7% SEC yield, and has outperformed other fixed-income asset classes since inception. JAAA is the safest, lowest-yielding fund in this space.
The Janus Henderson B-BBB CLO ETF ( JBBB ), which focuses on BBB-rated CLO tranches. JBBB has extremely low credit risk, negligible interest rate risk, sports a 8.6% SEC yield, and has outperformed other fixed-income asset classes since inception. JBBB is moderately riskier, higher-yielding than JAAA.
The Panagram BBB-B CLO ETF ( CLOZ ), which focuses on BB-rated CLO tranches. CLOZ has low credit risk, negligible interest rate risk, sports a 10.8% SEC yield, and has outperformed other fixed-income asset classes since inception. CLOZ is the riskiest, highest-yielding of the bunch.
In my opinion, the three funds above are all strong investment opportunities for income investors and retirees. JAAA seems best for more risk-averse investors, CLOZ for more aggressive, yield-seeking ones.
As an aside, there are several funds focusing on riskier CLO equity tranches available to investors too. In general terms I think these are good choices, but would have to take a much, much closer look to be certain that this is the case at current prices, NAVs, discounts, etc.
CLOs - Quick Explanation
Quick explanation of CLOs and CLO tranches work, before tackling the funds themselves.
Senior secured loans are variable rate loans from banks to medium-sized, riskier companies. There are exceptions, but not too many. These loans are senior to other debt and secured by company assets.
Senior loans are sometimes bundled together in CLOs. Each CLO, or bundle of senior loans, is divided into tranches. Income from the senior loans is used to make payments to all tranches. Senior tranches get paid first, junior tranches get paid last. Investors can buy into these tranches, and receive income from the bundle of senior loans. Quick graph of how these are structured.
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Senior loans are almost always variable rate loans, with most CLO tranches having variable rates too.
JAAA, JBBB, and CLOZ all invest in CLO tranches, so they all indirectly hold senior loans, and receive income for doing so. The tranches held by the ETFs vary, and so do their characteristics.
Let's now have a closer look at each of the funds above, starting with JAAA.
JAAA- AAA-Rated CLO ETF
Credit Risk - Extremely Low
JAAA focuses on AAA-rated CLO tranches, the senior-most tranche, with smaller investments in AA and A-rated tranches.
JAAA
JAAA's AAA-rated CLOs have extremely low default rates as these are the senior-most tranche. In other words, the fund and its investors get paid first, before all other tranches, and before almost all investors (they get paid at the same time as other AAA investors). The securities backing these CLOs effectively always generate sufficient income for the AAA tranche, so investors in these effectively always get paid too. As per S&P , not a single AAA CLO has ever defaulted, and the product has existed for several decades.
JAAA's AA and A-rated CLO tranches are a bit junior, so credit risk is very slightly higher. As per S&P, these have 10Y cumulative default rates of around 0.05%, less than 0.01% per year. Credit risk is quite low too.
CLO default rates, data as per S&P.
S&P
Interest Rate Risk - Extremely Low
JAAA's CLOs have variable rates of interest, so interest rate risk is extremely low.
JAAA's dividends tend to see swift, strong growth when the Fed hikes, as has been the case since early 2022. Growth has been higher than that of benchmark bond funds too.
Performance tends to be quite strong as well, with JAAA outperforming most relevant bond sub-asset classes since early 2022, too.
Dividends and Yield - Competitive 6.7% SEC Yield
JAAA sports a 5.4% dividend yield, meaning the fund has paid 5.4% in dividends these past twelve months. Said yield is accurate, but might not necessarily reflect the dividends investors can expect moving forward, considering recent Fed / dividend hikes.
JAAA sports a 6.7% SEC yield, which measures the actual income generated by the fund's underlying holdings in the past month. Said figure is more recent and up to date than the fund's dividend yield, and much more indicative of the dividends investors should expect moving forward. In my opinion, at least.
JAAA sports a 7.2% yield to worst, which measures the expected total returns from holding the fund's portfolio until maturity. Said figure is forwards-looking, with all the benefits and downsides that entails.
JAAA's dividends seem quite good, across all relevant yield metrics. JAAA's dividends compare favorably to most of its peers, with the fund yielding a bit more than T-bills, which have comparable credit and rate risk. JAAA also yields more than the average bond, even though the fund has quite a bit less credit and rate risk. High-yield corporate bonds do yield more, but have much greater credit risk.
Fund Filings - Chart by Author
JAAA's competitive, above-average dividends are an important benefit for the fund and its shareholders, especially considering the fund's low level of risk. JAAA is a low-risk, high-yield fund, a strong combination.
Performance Track-Record - Consistent Outperformance
JAAA's overall performance track-record is quite strong, with the fund consistently outperforming its peers, generally by very healthy margins.
Seeking Alpha - Chart by Author
JAAA's outperformance was in large part the product of good timing: JAAA has low interest rate risk, and was created a year and a half prior to a very aggressive set of rate hikes. Above-average dividends played a more minor, but positive, role in the fund's performance too.
JAAA's strong performance is a benefit for the fund and its shareholders but do consider the impact timing played on these.
On a more general note, JAAA's backwards-looking performance is quite good, as are the fund's more forward-looking dividend metrics. Seems like a very strong fund, all things considered.
Other Considerations
CLOs tend to be more volatile than expected based on their credit and interest rate risk, likely due to issues of market perception / market assessment of risk. JAAA, for instance, has about as much risk as T-bills, but is much more volatile.
Insofar as CLOs are more volatile than expected, investors, especially more short-term investors, are negatively impacted.
JAAA still compares favorably to some bond ETFs with similar volatility, although I had some difficulties in selecting these (nothing quite matched). A look at their volatility.
and at their performance since inception.
JAAA's higher-than-expected volatility is a negative for investors, but the fund still seems like a compelling investment opportunity to me.
I last covered JAAA here .
JBBB- BBB-Rated CLO ETF
Credit Risk - Extremely Low
JBBB focuses on BBB-rated CLO tranches, with smaller investments in AA and A-rated tranches.
JBBB
JBBB's BBB-rated CLO tranches are somewhere in the middle based on seniority, getting paid after several tranches, but before several other tranches too. Although there are obvious risks to this arrangement, risks are, in practice, tiny, as senior loans almost always generate more than sufficient cash to pay back investment-grade CLO tranches, including BBB tranches. As per S&P , BBB CLOs have annual default rates of just 0.01%, effectively equivalent to zero.
S&P
Considering the above, I think it would be fair to say that JBBB's holdings have extremely low credit risk, a straight-forward benefit for investors. Risks are higher than JAAA, however.
Interest Rate Risk - Extremely Low
JBBB's CLOs have variable rates of interest, so interest rate risk is extremely low.
JBBB's dividends tend to see swift, strong growth when the Fed hikes, as has been the case since early 2022. AGG included for reference.
Performance tends to be quite strong too, with JBBB outperforming most relevant bond sub-asset classes since early 2022, too.
Dividends and Yield - Competitive 8.6% SEC Yield
JBBB's dividends are higher than those of most bonds and bond sub-asset classes, across all three key yield metrics. In my opinion, the fund's 8.6% SEC yield, indicative of the income generated by the fund's underlying holdings these past thirty days, is particularly relevant for investors, but yields are high all around.
Fund Filings - Chart by Author
JBBB's strong dividends are a benefit for the fund and its shareholders, especially considering the fund's low overall risk. JBBB yields more than high-yield corporate bonds at much lower risk, a solid combination.
Performance Track-Record - Good Performance
JBBB's overall performance track-record is quite good, with the fund generally outperforming relative to peers. T-bills have outperformed since inception, however, as wider credit spreads led to some capital losses for JBBB in prior months (investors got spooked, sold BBB CLOs). JBBB's overall performance remains good enough, however.
JBBB
As with JAAA, JBBB's outperformance was in large part the product of good timing, but the fund's above-average dividends played a role as well.
As a final point, JBBB has underperformed relative to JAAA since inception, due to the aforementioned wider credit spreads.
Other Considerations
CLOs tend to be more volatile than expected based on their credit and interest rate risk, as is the case for JBBB. The fund is arguably closest to T-bills on an overall risk basis, a little bit riskier. JBBB is much more volatile, however.
Insofar as CLOs are more volatile than expected, investors, especially more short-term investors, are negatively impacted.
JBBB compares reasonably well to bond ETFs with similar volatility (or as similar as I was able to find). A quick look at their volatility.
and at their performance:
JBBB's higher-than-expected volatility is a negative for investors, but the fund still seems like a compelling investment opportunity to me. JAAA's past performance is much stronger, but I do believe that JBBB's higher dividends will make all the difference moving forward.
I last covered JBBB here.
CLOZ - BB-Rated CLO ETF
Credit Risk - Some
CLOZ focuses on BB-rated CLO tranches, with sizable investments in BBB-rated tranches, and smaller, temporary investments in cash vehicles.
CLOZ - Chart by Author
CLOZ's CLO tranches are somewhere in the middle of the pack in regards to seniority. Nevertheless, credit risk is overall quite low, with BB-rated CLOs having 10Y cumulative default rates of 2.3%, equivalent to 0.2% per year. BBB-rated CLOs are even safer, with 10Y cumulative default rates of 0.6%, less than 0.1% per year.
S&P
Default rates are quite low as CLOZ's holdings are senior to the junior-most equity CLO tranche, which are the first to bear losses from any default. In most cases, the junior-most tranche are the first and only tranche to bear any losses, as senior loan default rates are rarely high enough to completely wipe-out the junior-most tranche.
Notwithstanding the above, I believe that CLOZ's actual credit risk is somewhat higher than implied by the figures above, due to structural issues with CLOs.
Specifically, CLOs are structured in such a way that more junior tranches, especially BB-rated ones, could see significant losses from moderate , perhaps even small, default rates. In a situation in which the equity tranche is wiped out, the BB tranche is next, and would bear any and all losses before other tranches do. In other words, if senior loan default rates were to spike, CLOs would prioritize interest rate payments on AAA, AA, and other investment-grade tranches. BB-rated tranches would only receive payment after all tranches above receive theirs. If defaults rate spike, perhaps there will be little income left for investors in BB.
In my opinion, CLOZ has some moderate credit risk, which could lead to some losses during future downturns and recessions, and is a negative for the fund and its shareholders.
Interest Rate Risk - Extremely Low
CLOZ's CLOs have variable rates of interest, so interest rate risk is extremely low.
CLOZ's dividends should see swift, strong dividend growth when the Fed hikes rates. CLOZ is a relatively young fund, with inception in early 2023, so its dividend growth track-record is quite short, and not necessarily all that informative. Still, the fund's dividends have seen very healthy growth since inception. Table below excludes a small, partial dividend payment in January.
Performance should be quite strong too. As the fund is quite young, its performance track-record is quite short, and not necessarily informative. Still, the fund has outperformed since inception / during the current hike cycle, and by very healthy margins.
Although a closer, more in-depth analysis of CLOZ's performance might be of interest to investors, in my opinion the fund is simply too young for such an analysis to be all that informative.
Dividends and Yield - Competitive 10.8% SEC Yield
CLOZ sports the highest dividends in its peer group, with a 9.2% dividend yield, from annualizing its latest monthly dividend payment, and a 10.8% SEC yield. Both are very good figures, and higher than those of most bond sub-asset classes.
Fund Filings - Chart by Author
CLOZ's strong dividends are an important benefit for the fund and its shareholders, especially in comparison to high-yield corporate bond funds, securities with higher risks, but lower yields.
I last covered CLOZ here .
Conclusion
CLO ETFs offer investors strong dividends and effectively no interest rate risk. Credit risk varies, from negligible to moderate. Investors looking to capitalize on strong CLO yields have a variety of ETFs at their disposal. Three stand out.
JAAA, which focuses on AAA-rated CLO tranches. JAAA has negligible credit and interest rate risk, and sports a 6.7% SEC yield.
JBBB, which focuses on BBB-rated CLO tranches. JBBB has extremely low credit risk, negligible interest rate risk, and sports a 8.6% SEC yield.
CLOZ, which focuses on BB-rated CLO tranches. CLOZ has low credit risk, negligible interest rate risk, and sports a 10.8% SEC yield.
In my opinion, all three funds above are strong investment opportunities, and buys.
For further details see:
The Best 3 CLO ETFs For Income Investors And Retirees