A typical CLO structure has bonds across the ratings spectrum, in addition to an equity/first-loss tranche. CLO debt investors receive a set coupon over a floating-rate index, which is the Secured Overnight Financing Rate (SOFR) for US CLOs. This coupon increases as you move down the capital structure to compensate for the higher credit risk. We often compare the CLO capital structure to a bank (FIGURE 1), which has similar concepts of senior debt, subordinate debt, and equity.

CLOs Aren’t CDOs
Many investors group CLOs under the broader umbrella of collateralized debt obligations (CDOs). While both are securitized assets, they differ significantly, especially in terms of their underlying collateral.

CDOs are backed by residential mortgage-backed securities (including subprime mortgages), commercial mortgage-backed securities, and even other CDOs. These deals experienced extreme levels of defaults and losses during the Global Financial Crisis, and many senior AAA-rated CDOs failed to pay interest because of poor collateral performance. In contrast, CLOs are backed by bank loans, which are generally senior in the issuing company’s capital structure. This seniority has led to much higher recoveries in default scenarios.

In this piece, we focus on AAA CLOs, which we believe are the most attractive area within the CLO market. The AAA-rated tranche is the most senior tranche in the CLO capital structure and enjoys unique benefits such as:

1. Lower probability of default/loss during times of crisis
2. Lower historical volatility and drawdowns, and potential for higher yields relative to other fixed-income sectors
3. Diversification benefits compared to other fixed-income sectors

AAA CLOs have stronger safeguards against loan defaults relative to lower-rated bonds in the capital structure.

What Default?
CLOs have been issued for over 30 years, and the asset class has gone through several economic cycles, including a couple of crises such as the Global Financial Crisis and the COVID-19 pandemic. While CLOs did sustain mark-to-market drawdowns, no AAA-rated CLO tranche has ever defaulted. This is largely driven by the strong structures of CLOs. Most importantly, the AAA CLOs enjoy safeguards against loan defaults from the CLOs that sit lower in the capital structure and absorb losses first.

Additionally, there are stringent guidelines that CLOs must adhere to and certain stress thresholds that they have to pass, which are designed to protect investors from outsized losses on the underlying loans. With all of these structural protections, we estimate that a typical AAA CLO would begin to take principal losses when approximately 87% of the loan pool defaults. Reaching that level of default is a tall order, as the worst cumulative bank-loan issuer default rate has been 26% (FIGURE 2).

Volatility, Drawdowns, and Correlations
There are other standout features of AAA CLOs that make them compelling investments. FIGURE 3 compares historical volatility, drawdowns, and correlations of AAA CLOs with a few other fixed-income sectors. Regarding correlations, AAA CLOs have had a high correlation with bank loans, which isn’t surprising given that bank loans are the underlying collateral of CLOs, and both sectors are floating- rate investments. On the other hand, AAA CLO’s correlation with the Bloomberg US Aggregate Bond Index and the Bloomberg US Corporate Index is low, providing diversification benefits to investors who have exposure to some of these broader fixed-income asset classes.

AAA CLOs have performed better than many other asset classes in terms of volatility and max drawdowns. 

Additionally, AAA CLOs have performed better than many other asset classes in terms of volatility and maximum drawdowns. While the Bloomberg US 1-3 Year Corporate Index has had a similar maximum drawdown and volatility, it’s fallen short on return compared to AAA CLOs. The maximum monthly drawdown for AAA CLOs was 5%, which occurred in March 2020 at the peak of the pandemic. Despite being AAA-rated, these CLOs still have credit risk and can suffer price declines in market sell-offs; however, the Bloomberg US Corporate Index and the Bloomberg US Aggregate Bond Index had over three times the maximum drawdown of AAA CLOs.

We also looked at the drawdown experience across different sectors during a variety of risk-off events (FIGURE 4). As you can see, AAA CLOs stand out with little to no drawdowns in almost all periods except for the COVID-19 period, and even then, they experienced a smaller drawdown than most other sectors.

The Path Forward
We believe AAA CLOs distinguish themselves as a compelling, high-quality investment with attractive income and lower volatility compared to their fixed-income peers.

We anticipate demand for CLOs will continue, though not without some bumps in the road. Federal Reserve rate cuts could be one of those bumps, where some AAA CLO investors may shift a share of their assets to fixed-income sectors with higher duration. But if history is any guide, we know that it’s difficult to predict the future path of interest rates. Given the increasing unpredictability and volatility of economic cycles, we believe that a strategic allocation to AAA CLOs can provide an attractive income source and help investors navigate turbulent times.