Due diligence key to reaping benefits of CLOs

Text transcript

Welcome to Advisor to Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

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Aaron Young, executive director, head of client portfolio management, CIBC Asset Management 

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The outlook for collateralized loan obligations — or CLOs — especially against the macroeconomic backdrop we’re facing right now, remains healthy. Like a lot of credit asset classes, we’ve seen a healthy repricing of the CLO complex. And what that means for investors is, no longer are we facing all-in yields and spread levels that were at very tight ranges. We’ve actually now seen a backup in terms of spread and yield where we think there’s relative value back in the market. And they make a lot of sense as an investment alongside your core fixed-income holdings. 

Now, that doesn’t mean we’re out of the woods yet. That doesn’t mean that CLOs are impervious to all the macroeconomic, geopolitical, trade policy risks that are out there. But in the balance of risk-reward, the yield levels that we now see, even high-quality tranches — triple-A, double-A, single-A — are very interesting from an all-in yield perspective. 

The other thing I would mention is with CLOs — as listeners may know — they have near-zero interest-rate risk or duration risk. So against a backdrop of trade policy disrupting the reliability of the U.S. Treasury market as the global funding market, question marks around where does the Fed go from here? Are tariffs inflationary? Are they going to tip the U.S. economy into recession? All of those unknowns, you don’t really have to make decisions on those because you’re getting a floating-rate income product that resets every quarter. 

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One of the largest drivers of CLO issuance, even secondary market trading, is the underlying M&A activity and other corporate activities that require companies to come to what we call the broadly syndicated loan market. As that activity dies down, less need to borrow capital in the market. And the way to think about these broadly syndicated loans is they are really the input into CLOs. Without those inputs, you don’t have CLO structures, you don’t have tranches, etc. So as that has slowed down, that has definitely had an impact on CLO issuance. 

We still see it as a very healthy market. Lots of refinancing going into the marketplace, good levels on secondary trading. If you’re looking to buy pre-existing CLOs, still very healthy and still very attractive. 

One of the areas that it may impact more — which we generally have not been a holder of, but it is an area of the market — is CLOs based on direct loans. So not broadly syndicated loans that get issued by banks, but by direct deals much like the private-credit strategies that a lot of investors already have exposure to. As that deal flow dries up with lack of M&A activity in the background unknowns around trade policy — you know, how much are you going to invest in acquiring new businesses or expanding your business when you have that tariff overhang — as that volume slows down, that has a strong impact on CLOs that are comprised of direct lending or private-credit opportunities. Now, again, we don’t really play in that space right now, but that’s an area where you’ve seen some of the new issuance dry up just because there’s not enough inputs to create those CLOs. 

On the other hand, you know, this may be a small blip in the long march of history and direct lending CLOs, or middle-market private debt CLOs are a really interesting part of the market, set to continue to grow. They may just face short-term headwinds right now, which we think the market will work through eventually. 

In terms of broadly syndicated loans and the CLOs based on those, [they are] still very healthy. You need to know the underlying credit risk. You need to know the manager risk. But, at the end of the day, the market’s still functioning really well. 

And I would just remind listeners, for those based in Canada, we generally tend to have a home bias. We think of these markets as very small and niche. There are elements of the CLO market that are unique to just those instruments. But you need to remember, the size of the market itself — the amount of primary issuance secondary trading that goes on in CLOs versus asset classes we’re more accustomed to, like, say, Canadian investment-grade corporate bonds, high-yield — is very large. So there’s ample liquidity there. It ebbs and flows with market direction and with sentiment. But at the end of the day, it’s a very large and diversified market where we can source really interesting opportunities for our fixed-income funds. 

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For investors, when we hear CLOs, we think of exotic credit derivatives, structured product. We think of things that are really hard to understand. We even think of the Great Financial Crisis and CDOs — or collateralized debt obligations, which were based on subprime mortgages. We understand investors’ kind of knee-jerk reaction to think of those elements.  But CLOs are a bit different, and they’re actually a very well-established market, have been around a long time. The majority of the market is what we call triple-A tranches, or triple-A rated. That’s about 75%-plus of the market. These are high-quality, highly structured investments that garner that high-quality rating. And that’s really because the users of these investments are some of the largest and most-regulated institutional investors in the world. 

The use-case for triple-A, double -A CLOs has really been in bank balance sheets. So, ways to park money, earn attractive income on the balance sheet, but not take a lot of credit risk. And this is borne out by the fact that banks are regulated by different global regulations that require them to measure how much risk they have in their investments at any given point. Insurance companies, lifecos, property and casualty, these are highly regulated entities where their investments have to meet certain regulatory capital criteria. And pension funds use high-quality CLOs as a way to park capital, earn a decent income and, again, not go too far down the credit-risk spectrum where they start to have credit risk that’s equivalent to high-yield or private credit or any other parts of the market. 

So if you think of that as the playbook — kind of high-quality income — that’s really an interesting opportunity for any investor, whether you’re institutional or personal wealth. And that’s really where we see CLOs fitting in in the overall portfolio. It’s a chance to earn high-quality income without going too far down the credit-risk spectrum. 

And the other big element that I mentioned earlier is really the lack of interest-rate risk. And here the fixed-income team, here at CIBC Asset Management, we often talk about the difficulties with managing interest-rate risk, making the right calls. It’s hard to always get it right in terms of where is interest-rate policy going, etc. We’ve lived through the past five years where the market’s been dead wrong. If you can take a portion of your portfolio and remove that interest-rate risk, remove that unknown out of the equation without giving up on yield, that’s an interesting proposition. That’s part of what CLOs offer. 

And then just when you combine it all together, core plus bonds, core bonds, any kind of core corporate bond allocation sits really well alongside CLOs over time. [They have] lower correlations, one’s moving when the other’s not. That’s the kind of golden ticket you’re looking for when you’re trying to put the puzzle pieces together in terms of building a total fixed-income portfolio. 

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The opportunities with CLOs is access to an asset class that traditionally has not been available to the broader market. Again, it’s really been the area of expertise for banks’ balance sheets, life insurance companies, pension funds, asset managers. And this is a chance for investors across the board to add high-quality income into their portfolios and help diversify the main exposures that they have in their core fixed-income holdings. 

To take advantage of the opportunity, some key points that I think you want to look for is, as you buy CLOs or as you choose managers that buy CLOs: 

• What’s their understanding of the underlying assets that go into these, which is really just loans? What’s their experience looking at broadly syndicated loans, understanding these companies and issuers, maintaining quality, etc.? That’s a key element. 

• The second element really is manager understanding. So you’ve got to remember, every CLO has a CLO manager who’s actively managing that pool of loans. Much like when you’re buying a fund for a client or for yourself, you want to do due diligence on the manager. Make sure they know what they’re doing, they have experience, they’ve invested through many credit cycles, market cycles. Same with CLO managers. So do you have fixed-income PMs who understand the CLO managers, understand their strengths and weaknesses, and making sure they’re diversified across those managers? 

• And finally, structuring. These are in, some ways, structured products. One of the reasons you can get triple-A, double-A quality without giving up too much in yield is because there’s a structural element to it. Things like over collateralization, etc. So, making sure your active manager understands those structuring elements, making sure they understand something as boring as the paperwork that goes into CLOs to make sure it’s on par with what they’re seeing from other issuance CLO managers, etc. 

If you get those three ingredients right, we think you have a lot of opportunities, even beyond just triple-A tranches. If you know those three areas — the underlying collateral, the CLO managers and the structuring of the investment — you can actively allocate to double-A and single-A rated securities. You get extra yield pickup. There is a bit more credit risk and structural risk embedded in that. But if you understand it, the risk is worth it for the reward. 

We think that’s a really interesting area when you combine it with the majority high-quality AAA holdings. That’s really where we like to play in the CLO space.

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