Pretium believes that most investors who are allocating to high yield corporate bonds should also be considering bonds from the collateralized loan obligation (CLO) sector as well. Per Exhibit 1 below, BB rated CLO bonds have market yields of 13.9% as of November 22, 2022, vs. an average 7.2% yield for BB corporate bonds. Exhibit 2 shows that the extra yield that CLOs earn vs. corporate bonds, the CLO’s “complexity premium”, has grown in recent months, a trend that, we think, has improved the long-run value proposition associated with CLO debt. This yield premium reflects index, or average returns – i.e., “beta”. Industry researchers appear to share the view that CLOs can offer value, as highlighted by the quotations below:

• Morgan Stanley: “…we believe that the CLO market has more than priced in the downside risks, providing a large margin of safety and attractive risk-reward profile in the debt stack.”¹
• Bank of America: “We continue to see good value in securitized products credit relative to corporate credit, notably in credit risk transfer and CLOs.”²

This is not an offer, advertisement, or solicitation for interests in any Pretium managed vehicle and should not be construed or relied upon as investment advice or as predictive of future market or investment performance. Past performance is not indicative of future results.

While CLOs offer higher yields vs. corporate bonds, a Federal Reserve Bank of Philadelphia study shows that CLO bond instruments have historically had lower default rates compared with the default rates on similarly rated corporate bonds.⁴ CLOs are backed by senior secured bank loans to corporations, which typically offer higher recovery rates compared with unsecured corporate bonds⁵; this relatively high collateral quality has helped to limit losses for CLO bond investors. 

CLOs don’t require investors to make material bets on the direction of interest rates

The floating rate nature of CLO bonds tends to reduce risks to investors in high inflation, rising interest rate environments. The BBB rated corporate bond index has suffered a 17% loss in 2022 year-to-date through November 18, 2022; by contrast, the BBB rated CLO index has experienced just a 5% loss, reflecting the relatively lower sensitivity of CLOs to interest rate market drivers including inflation and Federal Reserve policy shifts.⁶

The CLO asset class has become too large to ignore

CLOs have become a large asset class; in part because of the strong and stable historical performance of the sector, the US CLO market has grown so that over 65% of the $1.4 trillion of leveraged loan debt outstanding is now owned within CLO vehicles.⁷ Reflecting the growth and maturation of the CLO asset class, a broad range of financial institutions – including banks, insurance companies, mutual funds, pension funds, private equity funds, private credit funds, and hedge funds – are now investing in CLOs.

Why do CLOs earn higher yields than comparably rated corporate bonds?

There are a few possible explanations for why bonds from the CLO sector consistently tend to earn higher yields in comparison with fixed rate corporate bonds. For one, while CLO liquidity has increased over time as the sector has grown, the bonds are not yet quite as liquid as generic corporate bonds. Second, CLO bond cashflows are determined by the performance of a pool of underlying loan assets, and so there may be a complexity premium vs. fixed rate bonds, which are simpler instruments with cashflows driven by a single underlying reference credit. Finally, we think the premium associated with CLOs in part reflects broad underinvestment in the sector, due to investor concerns that CLOs were connected to the problems associated with the global financial crisis. These concerns are, we think, misplaced; while CDO, RMBS and CMBS instruments indeed suffered high default rates in the 2007-2014 period, CLO structures performed far better, with low default rates and high realized returns.⁸ 

In light of the current high yields offered by CLO debt instruments, and the relative return stability of CLOs in periods of volatile interest rates, we think incorporating CLO debt can improve the risk/return profiles of many investors’ portfolios.