The Risks and Rewards of Chasing Yield in CLO ETFs

Collateralized loan obligations (CLO) have relatively high yields due to the credit risks associated with the corporate loans within their structure. CLOs transfer both the benefit of increased yields and the associated risks of the loan portfolio to investors. Therefore, knowing and understanding potential outcomes is crucial for making informed decisions. Despite their attractive yields, CLOs remain poorly understood by many stock market investors.

Understanding CLOs is crucial, even though most retail investors wouldn’t directly purchase a CLO. Instead, they can access a portfolio of various CLOs through exchange-traded funds (ETFs). These ETFs enable investors of all sizes to easily tap into CLO yields. While the recent performance and yields of CLO ETFs have attracted increasing interest, investors should approach them cautiously, weighing the associated risks before deciding to invest.

Examples of CLO ETFs

CLO ETFs like the BlackRock AAA CLO (NYSE:CLOA), Janus Henderson B-BBB CLO ETF (BATS:JBBB), and Panagram BBB-B CLO ETF (NYSE:CLOZ) are fixed-income ETFs tempting investors with their current one-year returns. These returns may look attractive, but it’s important to understand the complexities of CLOs and the considerations for investors chasing yields in these ETFs.

Of the three ETF CLOs being demonstrated above with the TipRanks Comparison Tool, two have a one-year return of over 16.5%, and one is almost half the others with a high 8% return.

How Do CLO ETFs Work?

To understand a CLO, imagine a file full of loan agreements from diverse companies, where some consistently meet their payment obligations while others do so less reliably. These loans each have contractual payment agreements with the lender, just like a family’s mortgage contract with a bank. The loans are securitized, which is a fancy name for bundled together into a single package. This is similar to how mortgages are bundled into mortgage-backed securities (MBS).

This package is then divided into different risk categories. Senior tranches (those that get paid before the others each month) are designed to be safer and offer lower returns, while junior tranches, which get paid only after there is enough money to pay the senior tranches, offer potentially higher returns but come with a greater chance of default.

When the economy is good, businesses are better equipped to manage these loans. In such scenarios, investors typically fare well with lower-grade secondary tranches in the underlying loans, which offer higher rates and are consistently paid off. However, if the economy weakens and even a small percentage of loans begin to default, returns on lower-tranche CLO ETFs will start to diminish.

Parallels to “The Big Short”

This all sounds too familiar if you read the book about hedge fund manager Michael Burry, The Big Short, or have seen the movie by the same name. This does not mean that the ending will be the same. Although securitizing debt contracts became common in the 1990s, problems have been rare since then, leading investors to maintain trust in financial engineers and rating agencies. Therefore, a significant short-term opportunity for CLOs is unlikely to arise.

However, investors should know that CLOs are not as transparent as exchange-traded stocks. This makes it difficult, even for professionals, to assess the creditworthiness of the underlying loans. This can be worrisome because if a significant portion of the loans default, investors will lose that fraction of the entire pool of loans. Worse yet, it can trigger a domino effect, impacting the entire CLO structure. This would lead to bigger losses for CLO ETF investors.

Key Risks to Consider Before Investing in CLO ETFs

The past yield on some CLO ETFs excites investors enough to cause them to overlook risks, unlike with other investments. Many perceive yields similar to bank CD rates, often considered a safe bet. However, unlike bank CDs backed by government-owned insurance, CLOs’ reliability depends on the borrowers’ business environment.

Alternatively, for yield, investors may instead consider dividend-paying stocks that offer regular payments and potential for growth. TipRanks can assist in finding stocks that have a consistent history of paying dividends.

Investor Tip

All investments carry risks and potential rewards, drawing those seeking better compensation for risk compared to alternative opportunities. There is no reason to believe that there is more or even less risk in CLO ETFs for the potential return compared to an indexed fund ETF or any other type. However, the risks of an equity-based ETF are more broadly understood, and the market for the underlying holdings in equity-based ETFs may be more liquid, adding inherent value.

In “The Big Short,” even major credit rating agencies were portrayed as not fully understanding the market risks of each tranche. For small investors with limited resources, exercising caution and thoroughly understanding the knowns and unknowns of CLO ETFs is essential.