BBB-rated mortgage loan obligations (CLOs) have “emerged as another category to consider”, along with high yield and leveraged loans, for investors looking for high capital, according to Janus Henderson Investors.
In a new research note, the firm said the inclusion of BBB CLOs in portfolios “can help improve risk-adjusted returns” due to their high credit ratings, low historical defaults, low correlation, and high historical returns compared to high-yield and leveraged loans.
Read more: Janus Henderson: The efficiency of the CLO sector is “zero”
BBB-rated CLOs have historically shown very low default rates, with only one default since 2007.
“Primarily, the low default rate is due to the credit enhancement feature within the CLO structure, where losses are brought first by the lowest-rated ratings, increasing to the highest-rated ratings as defaults increase,” wrote Janus Henderson Investors portfolio managers John P. Kerschner, Nick Childs, Jessica Shill, and Denis Struc.
“In a typical CLO structure, the BBB tranche won’t lose anything until the default rises above 10 percent. As a result, most of the losses historically have been absorbed by the lower-rated tranches.”
However, investors should be prepared for potentially higher volatility within the BBB CLO sector and less liquidity than high yield and leveraged loans, they cautioned.
Kerschner, Childs, Shill and Struc also noted that BBB CLOs “experienced similar, or sometimes greater, drawdowns” than senior loans and receivables.
They point to data showing that BBB CLOs recorded the highest decline of 11.6 percent, followed by high yield (9.7 percent) and receivables (6.7 percent) in the four most recent markets, with BBB CLOs selling “violently” during the Covid crisis.
Excluding Covid, high yield and BBB CLOs experienced a similar rate of decline, at around 8.7 percent and 8.4 percent, respectively.
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The portfolio managers suggested that the high volatility among BBB CLOs “is not necessarily an increase in CLO error during times of market stress”, and that their volatility is, instead, more closely linked to leveraged trading and downgrade risk.
“During flights to safety, money managers may look to liquidate assets that are easy to move, such as short-term bonds and floating-rate CLOs,” said Kerschner, Childs, Shill and Struck.
“Rating agencies tend to downgrade BBB CLOs when credit performance deteriorates, which can occur more often in shifts like Covid. In contrast, declines in interest rates and credit availability tend to be idiosyncratic, or specific and worded. While credit downgrades on BBB CLOs do not disrupt their cash flow, it reduces cash flow and investors to reduce the quality of the loan. It contributes to price volatility.”
The portfolio managers also noted that, despite their high volatility, BBB CLOs are highly uncorrelated relative to high yield and leveraged loans, adding that this “may reduce the potential negative impact of their high volatility within the diversified bond portfolio”.
Kerschner, Childs, Shill and Struc concluded that “with the right approach to navigating market volatility and maintaining a holistic view of the portfolio”, the volatility risk associated with BBB-rated CLOs can be “managed and mitigated”, making them a “compelling option” for portfolios.
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