This is an extract from an earlier article at Systematic Income Premium.
In this post, we take another look at AAA CLOs. The discussion is motivated by an interesting question we got on the service of how to compare the risk / reward of AAA CLOs and BBB corporate bonds.
This is a useful comparison because it cuts across three security features. First is the credit rating difference between AAA and BBB. Two, we are dealing with different assets: floating-rate bank loans that makeup CLOs vs. fixed-rate corporate bonds. And three, we have securitized, non-linear assets like CLO debt tranches and plain vanilla / linear assets like bonds.
The Risk Part Of The Equation
Let’s start off with risk profiles. Kicking off with CLOs, no AAA or AA CLOs rated by Moody’s ever defaulted. And only 1 AA CLO rated by S&P (out of 3200+ transactions) ever defaulted.
By contrast, the 3-5 year cumulative default rate for BBB-rated corporate bonds is between 0.6-1.3%.
It should be said that it’s not 100% straightforward to compare cumulative default rates as the weighted-average life of CLOs and corporate bonds are not the same as CLOs can be reset or refinanced with lower spreads while investment-grade corporate bonds are usually not callable.
Another important point is that the recovery on AAA CLO tranches (if one ever defaults) should normally be well above the recovery on BBB-rated corporate bonds. This is because a AAA CLO default is much more likely to involve a very small impairment of principal (due to higher historic loan recoveries as well as the fact that AAA tranches are impaired last in the CLO waterfall) while the average historic recovery on corporate bonds is around 40%. In other words, both the default rate and loss-given default are significantly lower for AAA CLO tranches.
Overall it’s clear that from a historical default perspective, AAA CLOs have done much better than BBB corporate bonds.
Something else to keep in mind is that the CLO structure has changed over time, starting with the so-called 1.0 version which went through the GFC, followed by 2.0 and now 3.0. Each iteration has enhanced structural protections for the debt tranches meaning, all else equal, the default rate should be lower for similarly rated debt tranches going forward than what we have seen in the past.
The Reward Part Of The Equation
Turning to reward, the intuitive conclusion from the risk discussion above is that AAA CLO “reward”, however defined, should be lower than that of BBB corporate bonds.
Let’s first look at credit spreads (called discount margin for loans and CLOs). What we have is that BBB-rated corporate bonds have a credit spread of 1.62% today according to FRED while AAA CLOs have spreads of 1.6-1.9% according to TCW and Palmer Square.
So you have the same or better compensation in AAA CLOs than you do for corporate bonds. Again, this is not quite apples-to-apples as CLO Debt is callable and callable debt should trade at wider spreads than non-callable debt, all else equal.
Where it gets really interesting is when we turn to yields. BBB corporate bonds have yields of 5.9% while AAA CLOs have a yield of around 7.2%. One way to gauge yields in the AAA CLO sector is to simply look at the portfolio yields of two funds that allocate to AAA CLO tranches. The Janus Henderson AAA CLO ETF (NYSEARCA:JAAA) has a portfolio yield of 7.3% (not to be confused with distribution yield which is lower) and the BlackRock AAA CLO ETF (CLOA) has a portfolio yield of 7.2%.
This big difference between AAA CLO yields and BBB bond yields is due to the inverted yield curve where CLO base rates are significantly above rates underlying corporate bonds. All in all, AAA CLOs win on both spread and yield counts.
An obvious question is what’s so special about AAA CLO tranches? Aren’t there a ton of other AAA-rated securitized or so-called “structured credit” assets? The chart below shows recent pricing for other AAA-securitized assets. We see that AAA CLOs are at the top end of the credit spread range but not at the very top.
Understandably, AAA CMBS securities are trading at even wider spreads, given concerns around the commercial and, specifically, office real estate market. LCF or so-called “last cashflow” securities are also trading at wider spreads. These securities get paid after all other AAA bonds have gotten paid off.
Overall, AAA-securitized assets that do trade at wider spreads have reasons for trading at those wider spreads, so we would stick with AAA CLOs in this product range.
Takeaways
The key takeaway in this article is that AAA CLO tranches have, if history is to be believed, little if any credit risk. And, due to their floating-rate profile they have practically no duration risk.
This doesn’t mean that AAA CLO tranches have no risk at all. What they do have is call risk where the CLO tranches can be refinanced in an environment of tighter credit spreads. They are also obviously more exposed to the drop in short-term rates if the Fed decides to move the policy rate lower. This is priced in to some extent by both the market and the Fed itself as shown below.
They also have a non-zero amount of mark-to-market risk – JAAA fell around 3% in price from the start of 2022 to the trough in October. Finally, AAA CLO vehicles such as the ETFs mentioned above, unlike cash or money market funds, don’t have perfect liquidity though JAAA is not bad on this front.
Another key point is that while our view is that AAA CLOs are the best risk/reward across the income space it doesn’t mean that that’s all everyone should own.
First, the yield of roughly 7.25% might not be all that high for many investors who look for even higher-yielding opportunities.
Two, many investors are happier to hold money-market funds at lower yields of 5% with the advantage that they know they can exit the position that trading day to put it to work elsewhere.
And three, while taking risk brings the potential for losses, it also has the potential for capital gains. For instance, at the moment we also like higher-quality duration to pair with floating-rate assets. This is because medium-term Treasury yields have backed up and are not far from their decade peak at the same time that disinflation continues apace.
If a recession does come, we should see a drop in Treasury yields which could, in turn, lead to capital gains on duration assets while keeping income levels fixed for several years. This is at the same time that floating-rate assets could see a drop in cashflows if the Fed decides to bring rates lower.
Overall, however, our view is that, in a diversified portfolio, AAA CLOs can play an important part in income allocation for more defensive investors.
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