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Is this description of CLOs from Morningstar accurate?
"Collateralized loan obligations are actively managed, diversified pools of non-investment-grade bank loans. They are structured investments where various tranches, or slices, of the structure carry different ratings, based on their protection from losses of the underlying pool of leveraged loans. The AAA rated tranche sits atop the capital structure and can absorb more losses than lower-rated tranches, down the line to the B rated and equity tranches, which are most exposed to losses."
Bank-loans are non-investment-grade or not-rated. So, a pool of bank-loans would also be non-inv-grade. But then, the restructuring magic is applied to slice-and-dice the portfolio in tranches of various quality - AAA,...,BB,....equity tranch.
M* shows JAAA as having only 7.65% as non-inv-gr & not-rated. Actually, funds are allowed to have 20-35% in off-label entities.
"Bank-loans are non-investment-grade or not-rated"
Interesting. Thanks @yogibearbull. I knew there was "magic" involved, but did not realize the extent.
"M* shows JAAA as having only 7.65% as non-inv-gr & not-rated."
True, but that is after all the magic is incorporated into that rating. The remaining 92.35% are investment grade CLOs, but not necessarily (and probably not) investment grade individual securities.
Bank-loans are non-investment-grade or not-rated. So, a pool of bank-loans would also be non-inv-grade. But then, the restructuring magic is applied to slice-and-dice the portfolio in tranches of various quality - AAA,...,BB,....equity tranch.
It's sort of like a company issuing bonds and preferred stock, both of which pay income (technically the former pays interest and the latter divs). If the company has trouble servicing its debt, the preferred stock suffers while the available cash is used to pay the bond interest. To the extent that tranches are "magic", so one can also view preferred stock as sorcery.
Janus and M* seem to differ slightly in their assessment of AAA CLO risk.
M*: "Default risk is remote for AAA CLO tranches" Janus: "Due to the credit enhancement features within CLO structures, there has never been a realized loss in any senior AAA, junior AAA, or AA rated CLO"
Here's a Portfolio Visualizer comparison using TRBUX as a baseline and PAAA, JAAA, and BBBIX (like TRBUX a "traditional" ultrashort fund, though with TF). The AAA CLO funds are less volatile resulting in higher Sharpe ratios. Nevertheless, M* gives them higher risk scores (though still 10 or under out of 100), vs. 4 for the traditional funds.
"CLOs are governed by a series of coverage tests that measure the adequacy of the collateral balance and the cash flows generated by the underlying bank loans."
Question 1: Who does the "governing" / "testing" to make sure it's even-handed / uniform? A rating agency like Standard & Poor's? The FDIC or SEC? Or is it left to the dealer (ie Janus)?
Trying to get my head around the relative credit risks of CLOs, Preferred, Corporates. All ISTM are backed by collateral.
Question 2: Would it be illegal or violate SEC rules if a fund identifying itself as an "Investment Grade Bond Fund" maintained a substantial position in CLOs?
M*: "Default risk is remote for AAA CLO tranches" Janus: "Due to the credit enhancement features within CLO structures, there has never been a realized loss in any senior AAA, junior AAA, or AA rated CLO"
I previously read that no AAA CLOs have defaulted during their entire existence (since 1992?). This is an excerpt from a KKR article that I read today.
"Not only does CLO debt offer similar or better carry to leveraged loans, but it also has a degree of added protection against defaults. Because rated debt tranches benefit from the subordination of equity and lower rated tranches, a CLO portfolio’s par value can decline significantly before rated debt tranches begin taking a principal loss. By our calculations, assuming a 50% recovery in the event of a default, which is more conservative than historical averages, nearly one-fourth of the underlying loans in a CLO portfolio would have to default before the CLO’s BBB-rated debt security experiences a single dollar of losses."
I considered investing in JAAA or PAAA a while ago but decided against it since I wasn't quite sure how these funds would perform during the Fed's easing cycle.
"CLOs are governed by a series of coverage tests that measure the adequacy of the collateral balance and the cash flows generated by the underlying bank loans."
Question 1: Who does the "governing" / "testing" to make sure it's even-handed / uniform? A rating agency like Standard & Poor's? The FDIC or SEC? Or is it left to the dealer (ie Janus)? [snip]
A Nationally Recognized Statistical Rating Organization (NRSRO) such as Fitch Ratings, Moody’s Investor Service, or Standard and Poor’s will assess the credit quality of CLOs.
Similarly, CLOs are governed by their terms. Nothing, um, magical here. The terms of the CLO require the CLO issuer to perform certain tests (which in turn could entail the issuer making demands of the banks under the terms of their loans).
Just as a bond is in default if the issuer doesn't comply with the covenants, a CLO is in default if it doesn't comply with its terms. It's up to the CLO manager to buy bank loans with terms it is happy with, and it's up to the ETF manager to buy CLO tranches with terms it is satisfied with.
Here's a long, detailed description of all the participants and what their roles are in CLOs. The ETF manager plays the "investor" role.
Q2: This can be transformed into: a) is a CLO a bond, and b) are its BBB or better tranches investment grade?
The answer to the latter is yes - the Bloomberg Law piece explains how rating agencies are called in to rate the tranches. As to the former, Vontabel writes that CLOs are bond instruments. Regarding its tranches, I'd have to check further, though I don't think that's your main concern.
Unable to access the Vontabel piece: "The page you are looking for is not available to your investor type, region or IP address." Could be my VPN which I haven't figured out how to switch off in IOS 26 short of deleting the security app responsible.
From @msf - "CLOs are bond instruments." Interesting way of putting it. In that case, the "bond fund" you or I own might be a CLO fund under the wrapper.
From @Observant1: "A Nationally Recognized Statistical Rating Organization (NRSRO) such as Fitch Ratings, Moody’s Investor Service, or Standard and Poor’s will assess the credit quality of CLOs. In that case, I'd be less prone to worry. That's their job. What they're paid to do.
Unable to access the Vontabel piece: "The page you are looking for is not available to your investor type, region or IP address."
I think you need to say you are a professional to get in. I only cited it because it was a financial institution using CLO and bond in the same sentence. One could probably make the connection from a structured debt instrument to a bond much as one can say a GNMA structured debt instrument to a GNMA bond. Either way, they're pools of income streams bundled together into an interest-paying security sold to investors. And no one balks at something called a "GNMA bond fund".
I looked for a short cut - an institution that assumed the connection.
Dedicated CLO funds now reside in the new Morningstar "Securitized Bond - Focused" category. This category also includes funds which focus on commercial mortgages and Asset-Backed Securities. Fidelity Fund Screener
Comments
https://www.morningstar.com/etfs/arcx/jaaa/analysis
"Collateralized loan obligations are actively managed, diversified pools of non-investment-grade bank loans. They are structured investments where various tranches, or slices, of the structure carry different ratings, based on their protection from losses of the underlying pool of leveraged loans. The AAA rated tranche sits atop the capital structure and can absorb more losses than lower-rated tranches, down the line to the B rated and equity tranches, which are most exposed to losses."
Bank-loans are non-investment-grade or not-rated. So, a pool of bank-loans would also be non-inv-grade. But then, the restructuring magic is applied to slice-and-dice the portfolio in tranches of various quality - AAA,...,BB,....equity tranch.
M* shows JAAA as having only 7.65% as non-inv-gr & not-rated. Actually, funds are allowed to have 20-35% in off-label entities.
Interesting. Thanks @yogibearbull. I knew there was "magic" involved, but did not realize the extent.
"M* shows JAAA as having only 7.65% as non-inv-gr & not-rated."
True, but that is after all the magic is incorporated into that rating. The remaining 92.35% are investment grade CLOs, but not necessarily (and probably not) investment grade individual securities.
Guggenheim has a pretty good writeup of how CLOs work.
https://www.guggenheiminvestments.com/perspectives/portfolio-strategy/understanding-collateralized-loan-obligations-clo
Janus and M* seem to differ slightly in their assessment of AAA CLO risk.
M*: "Default risk is remote for AAA CLO tranches"
Janus: "Due to the credit enhancement features within CLO structures, there has never been a realized loss in any senior AAA, junior AAA, or AA rated CLO"
https://www.janushenderson.com/en-us/advisor/article/the-art-and-science-of-managing-aaa-clo-portfolios/
The difference may be due to a subtle wording shift, from "default risk" (including technical/contractual defaults) to "realized loss".
In any case, if risk is a concern with AAA CLO ETFs, PAAA maintains an even higher grade mix of CLOs than JAAA. And FWIW, M* gives PAAA a higher medal rating (by humans, not computer).
https://seekingalpha.com/article/4830794-paaa-defensive-yield-in-uncertain-times
Here's a Portfolio Visualizer comparison using TRBUX as a baseline and PAAA, JAAA, and BBBIX (like TRBUX a "traditional" ultrashort fund, though with TF). The AAA CLO funds are less volatile resulting in higher Sharpe ratios. Nevertheless, M* gives them higher risk scores (though still 10 or under out of 100), vs. 4 for the traditional funds.
From the Guggenheim piece,
"CLOs are governed by a series of coverage tests that measure the adequacy of the collateral balance and the cash flows generated by the underlying bank loans."
Question 1: Who does the "governing" / "testing" to make sure it's even-handed / uniform? A rating agency like Standard & Poor's? The FDIC or SEC? Or is it left to the dealer (ie Janus)?
Trying to get my head around the relative credit risks of CLOs, Preferred, Corporates. All ISTM are backed by collateral.
Question 2: Would it be illegal or violate SEC rules if a fund identifying itself as an "Investment Grade Bond Fund" maintained a substantial position in CLOs?
Janus: "Due to the credit enhancement features within CLO structures,
there has never been a realized loss in any senior AAA, junior AAA, or AA rated CLO"
I previously read that no AAA CLOs have defaulted during their entire existence (since 1992?).
This is an excerpt from a KKR article that I read today.
"Not only does CLO debt offer similar or better carry to leveraged loans,
but it also has a degree of added protection against defaults.
Because rated debt tranches benefit from the subordination of equity and lower rated tranches,
a CLO portfolio’s par value can decline significantly before rated debt tranches begin taking a principal loss.
By our calculations, assuming a 50% recovery in the event of a default, which is more conservative
than historical averages, nearly one-fourth of the underlying loans in a CLO portfolio would have to default
before the CLO’s BBB-rated debt security experiences a single dollar of losses."
https://www.kkr.com/insights/clo-liabilities-in-credit-portfolios
I considered investing in JAAA or PAAA a while ago but decided against it
since I wasn't quite sure how these funds would perform during the Fed's easing cycle.
Angel Oak Capital Advisers suggests that it might be a good time to pivot away
from AAA-rated CLOs due to lower short-term rates and the likelihood of an economic slowdown.
https://angeloakcapital.com/overlooked-risks-in-aaa-rated-clos/
Moody’s Investor Service, or Standard and Poor’s will assess the credit quality of CLOs.
https://analystprep.com/cfa-level-1-exam/fixed-income/bond-indentures-and-covenants/
Similarly, CLOs are governed by their terms. Nothing, um, magical here. The terms of the CLO require the CLO issuer to perform certain tests (which in turn could entail the issuer making demands of the banks under the terms of their loans).
Just as a bond is in default if the issuer doesn't comply with the covenants, a CLO is in default if it doesn't comply with its terms. It's up to the CLO manager to buy bank loans with terms it is happy with, and it's up to the ETF manager to buy CLO tranches with terms it is satisfied with.
Here's a long, detailed description of all the participants and what their roles are in CLOs. The ETF manager plays the "investor" role.
https://www.bloomberglaw.com/external/document/X2V6L7EG000000/finance-professional-perspective-clo-structures-risks-and-partic
Q2: This can be transformed into: a) is a CLO a bond, and b) are its BBB or better tranches investment grade?
The answer to the latter is yes - the Bloomberg Law piece explains how rating agencies are called in to rate the tranches. As to the former, Vontabel writes that CLOs are bond instruments. Regarding its tranches, I'd have to check further, though I don't think that's your main concern.
From @msf - "CLOs are bond instruments."
From @Observant1: "A Nationally Recognized Statistical Rating Organization (NRSRO) such as Fitch Ratings, Moody’s Investor Service, or Standard and Poor’s will assess the credit quality of CLOs. In that case, I'd be less prone to worry. That's their job. What they're paid to do.
I think you need to say you are a professional to get in. I only cited it because it was a financial institution using CLO and bond in the same sentence. One could probably make the connection from a structured debt instrument to a bond much as one can say a GNMA structured debt instrument to a GNMA bond. Either way, they're pools of income streams bundled together into an interest-paying security sold to investors. And no one balks at something called a "GNMA bond fund".
I looked for a short cut - an institution that assumed the connection.
This category also includes funds which focus on commercial mortgages and Asset-Backed Securities.
Fidelity Fund Screener