Collateralised loan obligations (CLOs) theoretically contain only leveraged senior secured loans and, in principle, are more solid and trustworthy than the collateralised debt obligations or CDOs that helped trigger the 2008 global financial crisis.
CLOs combine diverse loans into a single tradeable security and can offer a higher yield than a single loan with roughly the same notional level of risk and credit rating.
Recent regulatory easing of CLO exchange-traded funds in Europe has boosted the race between providers. Luxembourg and Ireland are both now positioning themselves as domiciles for CLO ETFs within the UCITS structure as Europe catches up with an investment fashion that began in the US.
But CLOs and ETFs are somewhat contradictory, ETFs are typically liquid and transparent with excellent visibility into the underlying assets they trade.
CLOs are anything but transparent. As bags of private loans, they are inevitably opaque. Some divergence between the true underlying net asset value and the current quoted NAV is practically inevitable. Moreover, it is up to the structuring entity and ratings agencies to put together a sound and properly rated package of loans for CLOs, which raises further cause for concern.
The triple A rating of many CLO ETFs is a puzzle in itself. A typical CLO ETF, iShares AAA CLO Active ETF, invests principally in CLOs that carry the triple A rating. Time was when a triple A was only given to a a few rock solid sovereigns. So what does a triple A rating mean for CLOs?
According to the Financial Times, these CLOs are usually put together out of loans to companies frequently backed by private equity that are rated BB or B. But through the alchemy of collateralisation, the resulting CLO can offer access only to loan tranches rated triple A.
CLO ETFs are a hot product right now, which means buyers may end up paying even more. By late 2024, according to S&P Global, total assets under management in CLO ETFs had risen to over US$19 billion from just $120 million in 2020 off the back of strong investor demand. According to the FT, assets were close to $30 billion by April this year.
Such fast growth ought to raise red flags: are CLO ETFs outrunning proper oversight and risk management?
To be sure, all the reassurance around the greater reliability of CLOs versus CDOs may be justified. Regulators may be on top of the evolving asset sub-class. But investors should keep a very careful eye on just what they are getting, and how it is performing, and to use the fabled transparency of ETFs to sell out of their CLO ETF positions the moment things start to go south.
