Due diligence key to reaping benefits of CLOs

As uncertainty in markets continues, collateralized loan obligations (CLOs) offer investors decent yield with near-zero interest-rate risk, says Aaron Young, executive director, head of Client Portfolio Management at CIBC Asset Management.

They’re especially attractive, he said, in today’s economy, marked as it is by trade wars, geopolitical risks and the potential return of inflation.

“All of those unknowns, when investing in a floating-rate security like a CLO, you don’t really have to make decisions on those because you’re getting a floating-rate income product that resets every quarter,” he said in a May 5 interview.

Listen to the full conversation on the Advisor To Go podcast, powered by CIBC Asset Management.

Young added that one of the largest drivers of CLO issuance continues to be merger and acquisition activity. As that’s slowed down, it has impacted CLOs, especially those based on direct loans.

“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,” he said.

Direct loans is not a space his team is currently invested in. He prefers the broadly syndicated loan market, which is comprised of leveraged bank loans, and is considered “still very healthy.” That includes AAA-rated CLOs, which make up about 75% of the market.

“These are high-quality, highly structured investments that garner that high-quality rating,” Young said. “And that’s really because the users of these investments are some of the largest and most regulated institutional investors in the world.”

This includes banks as well as life and property and casualty insurance companies, which must meet regulatory capital criteria. Pension funds also use CLOs as a way to “park capital” and “earn a decent income,” he added.

So whether you’re an institutional or personal wealth investor, CLOs offer a chance to earn “high-quality income without going too far down the credit risk spectrum,” Young said.

The key to investing is to use CLOs to diversify core fixed-income holdings as part of an overall portfolio, he said. In fact, CLOs and core corporate bond allocations have lower correlations.

“One’s moving when the other’s not,” Young said. “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.”

He suggested investors screen CLO managers to make sure they are experienced, have an understanding of the underlying assets, and have managed those loans through a variety of credit cycles.

“What’s their experience looking at broadly syndicated loans, understanding these companies and issuers, [and] maintaining quality?”

Young noted managers should also understand the structured part of CLOs, including collateralization.

“If you know those three areas, the underlying collateral, the CLO managers, and the structuring of the investment, you can actively allocate to AA- and A-rated securities,” Young said. “You get extra yield pickup.”

This article is part of the Advisor To Go program, sponsored by CIBC Asset Management. The article was written without input from the sponsor.