Amid low rates, CLOs appear attractive vs. similarly rated high yield bonds
Source: Bloomberg Finance, L.P., as of February 5, 2021. CLO LIBOR spreads vs. corporate bond spreads to swaps by rating level. CLOs refer to collateralized loan obligations.
- Stocks have continued to climb in February and this week reached a new all-time high. Amid the stock market’s climb, yields across the bond market have plumbed new lows. At approximately 1.2%, the yield on the Barclays Agg sits just above its all-time low while high yield bond yields fell this week to a record low of 4.56%.1
- While fixed income investors have enjoyed generally strong returns over the last several years, the majority of those returns have been driven by capital appreciation thanks to falling rates. Given the low starting point for yields today, traditional fixed income portfolios have significant downside risk if rates rise, yet little upside if rates were to fall further.
- Against this backdrop, investing in alternative credit strategies focused on opportunities outside of traditional benchmarks, such as collateralized loan obligations (CLOs), may provide investors the opportunity for above-market income and differentiated returns. CLOs are securities backed by a pool of corporate loans.
- As the chart highlights, CLOs offer significantly higher spreads (or yields above the risk-free rate) than similarly rated high yield bonds.2 While CLOs have historically traded wider (higher spreads to Treasuries) than high yield bonds, the spread differential between the two asset classes is much wider today than its historical average.
- This suggests that there remains plenty of room for CLO spreads to tighten – and prices to rise – if spreads were to revert to the historical average.
- It’s important to note, of course, that CLOs are often highly illiquid compared to individual high yield bonds or loans and typically comprise multiple tranches of debt that feature varying levels of risk. Because of their complexity and limited liquidity, CLOs are not widely owned by mutual funds and ETFs and are often best accessed using managers with the expertise and infrastructure necessary to analyze and determine a CLO’s intrinsic value and potential for longer-term total return.