By contrast, the underlying collateral backing CLOs are pooled loans to business corporations. These loans are packaged together by CLO management firms which, in turn, sell them on the secondary market to institutional investors.
The loan packages, or pools, are divided into tranches with different credit ratings and yields. As for duration risk, the underlying loans have floating rates, so CLOs are less sensitive than conventional bonds to changes in market rates.
Toronto-based Brompton Funds Ltd. became the first to offer a CLO ETF in Canada with the April 22 launch of Brompton Wellington Square AAA CLO ETF. It was followed in May by BMO AAA CLO ETF, RBC AAA CLO ETF, CIBC Income Advantage Fund — which is the ETF series of a new mutual fund — and Mackenzie AAA CLO ETF.
Trillion-dollar market
CLOs have been around for more than 30 years, and have grown to be a US$1.1-trillion-plus market, nearly all U.S.-based, said portfolio manager Jeff Sujitno of Wellington Square Advisors Inc. The Toronto-based firm specializes in leveraged finance.
Citing J.P Morgan research, Sujitno said there are currently 115 to 120 CLO managers in the U.S, and 1,400 to 1,600 CLOs to choose from.
Up until five years ago, CLOs were available solely to institutional investors. Retail investors first gained indirect access in October 2020 with the launch in the U.S. of Janus Henderson AAA CLO ETF. The market leader now has assets of about US$21 billion and has been a strong performer in its Ultrashort Bond peer group, receiving a 5-star Morningstar Rating.
“Given the performance of these ETFs in the U.S., we felt it made sense for a Canadian-listed vehicle,” said Mark Jarosz, head of credit alternatives with BMO Global Asset Management. “I think it’s one of the more exciting innovations in the last few years in the ETF space.”
Diversification is a strong suit for CLO ETFs, since they invest in tranches of loans assembled by CLO management firms, rather than directly in the loans. CIBC’s offering, for instance, will initially hold 30 to 50 loan pools, diversified by CLO manager, the underlying loans and terms to maturity.
BMO’s Jarosz said each CLO pool has 200 to 300 underlying loans. On a portfolio-wide basis, that works out to an ETF having exposure to thousands of corporate loans.
Along with borrower diversification, CLO managers employ various other risk-mitigation methods. Among them, as noted by Mackenzie Investments, are overcollateralization, interest-coverage tests, collateral-concentration limits by industry sector and restrictions on the purchase of loans to small companies. These measures are important because the borrowers are corporations whose credit ratings are below investment grade.
Default risk
There is default risk embedded in CLOs, “just as there is in any fixed-income instrument where you’re taking on credit risk,” said Aaron Young, executive director and head of client portfolio management with CIBC Asset Management Inc.
This risk can be mitigated by focusing on triple-A rated CLOs, which rank ahead of all other tranches in the event of defaults. What Young calls “structural safety” is also accomplished through exposure to a large number of underlying borrowers from different industries.
“That gives you the additional peace of mind to know that this is actually a highly diversified pool of loans that deserves that triple-A rating or double-A rating,” he said.
The new Canadian-listed ETFs invest primarily in triple-A rated CLO tranches. These represent about 64% of the CLO market and have never experienced a default, said Sujitno, adding that there has only been one default of a double-A CLO tranche.
The Brompton ETF will always be at least 75% invested in triple-A tranches. In selecting CLO managers, Sujitno said considerations include the quality and track record of that team, and the performance of their CLOs over time in various market environments. “There’s a myriad of credit metrics that we would look at.”
Though CIBC Income Advantage Fund has a more generic name, it’s a pure play on CLOs, said Young. At all times it will hold at least 80% of its portfolio in triple-A CLOs, and won’t hold anything rated lower than single-A. This is consistent with the fund’s focus on “higher-quality income and not introducing undue amounts of credit-quality risk.”
BMO AAA CLO ETF is currently holding only triple-A tranches, and these will always represent at least 85% of the portfolio. BMO’s investment policy allows it to invest up to 15% in double-A or single-A CLO tranches, but nothing lower than that. “Absolutely not,” said Jarosz. “This is an investment-grade product with the primary investment thesis of investing in triple-A securities.”
All of the new CLO ETFs offer currency-hedged Canadian-dollar versions, shielding investors from exchange-rate volatility. “Bottom line, we want a smooth ride for folks,” said Sujitno. BMO and Brompton also offer U.S.-dollar versions.
Additionally, BMO created an unhedged Canadian-dollar version. Jarosz said BMO wants to give investors a choice, depending on their preference for currency exposure.
Because of potential confusion with CDOs and their tarnished reputation, there’s a need for ETF providers to explain clearly what sets CLOs apart. “If you look beyond just the three-letter acronym, what we really are comfortable telling investors is that the inputs are completely different,” said CIBC’s Young.
The loans that go into the CLO structures, he said, are borrowings by large U.S. corporations with earnings that are generally in the range of US$50 million or more. The failed CDOs held mortgages taken out by individuals with poor credit histories.
Triple-A-focused CLO ETFs complement core bond holdings that are much more interest-rate sensitive. With CLOs, “you’re dampening some of the volatility that comes with unknowns around where interest rates are going from here,” said Young.
A related positive attribute of CLOs is their low correlation to the mainstream bond markets, resulting in greater diversification. “You can see it’s additive over long periods of time in terms of not only increasing yield, but reducing risk,” said Young. “That’s really what you’re looking for. CLOs have delivered on that over time.”