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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
I asked Google AI, "How long have CLOs been around". It said about 40 years, but there have been MANY changes: CLO-initial, and CLO 1.0, 2.0 (it emerged after GFC that crushed CDOs), 3.0 (now).
CLO is a subclass of CDOs. CLOs have been battle-modified, but has their popular form CLO 3.0 been fire-tested.? The worst case 50% recovery is just an assumption. Could some underlying portfolios do worse in the next debt-crisis? As a made up example, there are various cuts of beef, but if the herd is found to have Mad Cow disease (BSE), do you still eat your Prime steak and risk vCJD?
I think it's OK to have some JAAA, PAAA, etc.
"AI Overview (Google Gemini)
CLOs (Collateralized Loan Obligations) have been around since the late 1980s, created by banks to bundle leveraged loans, with the "modern" structure emerging in the mid-to-late 1990s to offer investors different risk/reward tranches, evolving through vintages (CLO 1.0, 2.0, 3.0) with regulatory changes, and proving resilient across multiple market cycles.
Key Milestones:
Late 1980s: The concept of bundling loans into securities (CLOs) began, mirroring earlier mortgage-backed structures to manage bank balance sheets.
Mid-to-Late 1990s: The first "modern" CLOs (CLO 1.0) were issued, packaging loans and some high-yield bonds, becoming the market standard.
2008 Financial Crisis: Issuance dried up, but CLO structures proved more resilient than CDOs, leading to tighter credit support and reinvestment rules (CLO 2.0).
2012 Onward: The US CLO market rebounded, with increased issuance and greater acceptance, leading to CLO 3.0 vintages focusing on reduced risk.
In essence, CLOs have a history spanning over three decades, adapting to financial shifts while offering diverse fixed-income opportunities. "
Good point by @msf re pools of mortgages. You or I might not receive an AAA bond rating by ourselves no matter how responsible we are. But a pool including our mortgage along with thousands of others of the same creditworthiness might.
This Lord Albert piece is one of the better I've stumbled upon re the risk profile of CLOs. I feel these are quite safe, but as @msf suggests in mentioning PAAA, the fund sponsor has room to either strengthen or weaken his offering in ways most of us might not be aware of. That's of course true of other financial products offered.
Related / Unrelated - Bloomberg is reporting today a bid to buy Janus Henderson. When I searched , it seems there has been speculation + bids to buy the firm going back at least to 2020.
Janus Henderson/JHG bought by Trian (already owned 20.6%), General Catalyst and others including Qatar Investment Authority, Sun Hung Kai & Co. Limited, MassMutual, etc.
I'm a big fan of BBBMX/BBBIX, but the duration, while miniscule, is about three times that of the funds linked to by @msf. Considering the topic, I'll add this from the folks at BBH:
We only invest in credits we believe to be durable, well-managed, appropriately structured, and that can be comprehensively researched and understood.
There has been a lot of discussions as well as dire warnings in recent months on CLOs, BDCs, and ABS bonds. The three funds that come to mind with heavy allocations to these three bond areas are HOSIX in CLOs, HOBIX in BDC bonds, and SCFZX in ABS. Check out their performances over the past one and three months. No signs of stress there, In fact, steady as a rock with almost zero volatility.
"I'm a big fan of BBBMX/BBBIX, but the duration, while miniscule, is about three times that of the funds linked to by @msf."
I have a T-Bill maturing in early January. The proceeds will be funneled into BBBIX. BBBMX was previously held in a different account.
I certainly could easily simplify my IRA by getting into BBBIX. Hmmmm. Kind of waiting for the next inflation readout before I start rearranging the deck chairs
I'm a big fan of BBBMX/BBBIX, but the duration, while miniscule, is about three times that of the funds linked to by msf.
The difference is likely due to CLOs being invested in floating rate instruments while BBBIX is a traditional ultrashort bond fund. This mention of duration (and hence volatility) raises the question of risk.
Volatility is commonly used as a proxy for risk but they're not the same; at most volatility is just one aspect of risk. There is structural risk - how the portfolio is designed - what is the risk of it falling off a cliff? Instinctively that may be what some are wondering about with CLOs.
Yogi alluded to this in writing of CLOs as "battle-modified" and analogizing to mad cow disease, i.e. something that could affect an entire industry. In one sense, I agree with the concern that the CLOs may be building a Maginot line, preparing for the last "war".
That said, the financial industry seems to have done a pretty good job of protecting against another outbreak of mad cow disease. CDOs collapsed when subprime mortgages collapsed. CDOs were largely invested in a single sector. CLOs are not.
ConAgra doesn't just invest in beef (e.g. Hebrew National) but in corn (e.g. Orville Redenbacher) and a plethora of other foodstuffs. Similarly,
For diversification purposes, CLOs are structured with specific investment limitations, such as issuer and industry concentrations, which aim to protect investors from potential losses. For example, a CLO’s underlying portfolio may consist of 100 or more issuers across several industries.
Diversification across multiple industries is not just fighting the last war, it's more generally a "Healthy Choice®".
Nevertheless, CLOs carry some risk of the unknown. Though they have added various safeguards to make the chance of a meltdown remote, it isn't zero. I view CLOs as a small step along the risk/reward trajectory. Slightly more risk than something like BBBIX with a modestly greater expected return.
Very educational thread. Thank you to all who answered my query. FWIW I did move out of JAAA and into PAAA during a major reshuffle yesterday. M* agrees with @msf that PAAA adheres to slightly higher credit quality and speaks highly of its experienced managers. I currently split what I term "cash" (your definition may vary) between PAAA and AGZD. The latter is a rate-hedged approach to the Bloomberg Aggregate (investment grade) Bond Index.
My own feelings are that even if short term rates are pushed lower by a politically pressured Fed, longer term rates won't necessarily fall, could actually rise in response, and might yield appreciably more than the short end. That would actually drive down bond prices - hence the rate hedge. There is one "fly in the ointment" however. The Fed may seek to keep long term rates low by ramping up QE (buying longer dated bonds). In that case you'd be better off not hedging rates. It's all very confusing, but generally, I don't like to carry interest rate risk. Have enough other things that could go wrong without adding complexity. Hope my analysis makes sense.
"The Fed may seek to keep long term rates low by ramping up QE (buying longer dated bonds)."
I'm concerned about this as well. Since the Fed's easing cycle began in 2024, long-term rates have actually gone up. There is a high probability that the Fed will start QE again if long-term rates remain high. The Fed ended quantitative tightening (QT) at the end of November and then immediately increased new purchases of T-Bills.
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
CLO is a subclass of CDOs. CLOs have been battle-modified, but has their popular form CLO 3.0 been fire-tested.? The worst case 50% recovery is just an assumption. Could some underlying portfolios do worse in the next debt-crisis? As a made up example, there are various cuts of beef, but if the herd is found to have Mad Cow disease (BSE), do you still eat your Prime steak and risk vCJD?
I think it's OK to have some JAAA, PAAA, etc.
"AI Overview (Google Gemini)
CLOs (Collateralized Loan Obligations) have been around since the late 1980s, created by banks to bundle leveraged loans, with the "modern" structure emerging in the mid-to-late 1990s to offer investors different risk/reward tranches, evolving through vintages (CLO 1.0, 2.0, 3.0) with regulatory changes, and proving resilient across multiple market cycles.
Key Milestones:
Late 1980s: The concept of bundling loans into securities (CLOs) began, mirroring earlier mortgage-backed structures to manage bank balance sheets.
Mid-to-Late 1990s: The first "modern" CLOs (CLO 1.0) were issued, packaging loans and some high-yield bonds, becoming the market standard.
2008 Financial Crisis: Issuance dried up, but CLO structures proved more resilient than CDOs, leading to tighter credit support and reinvestment rules (CLO 2.0).
2012 Onward: The US CLO market rebounded, with increased issuance and greater acceptance, leading to CLO 3.0 vintages focusing on reduced risk.
In essence, CLOs have a history spanning over three decades, adapting to financial shifts while offering diverse fixed-income opportunities. "
This Lord Albert piece is one of the better I've stumbled upon re the risk profile of CLOs. I feel these are quite safe, but as @msf suggests in mentioning PAAA, the fund sponsor has room to either strengthen or weaken his offering in ways most of us might not be aware of. That's of course true of other financial products offered.
Related / Unrelated - Bloomberg is reporting today a bid to buy Janus Henderson. When I searched , it seems there has been speculation + bids to buy the firm going back at least to 2020.
JHG Press Release https://ir.janushenderson.com/News--Events/news/news-details/2025/Janus-Henderson-Group-plc-to-be-Acquired-by-Trian-Fund-Management-and-General-Catalyst-for-7-4-Billion/default.aspx
NEWS
CNBC https://www.cnbc.com/2025/12/22/asset-manager-janus-henderson-gets-bought-by-trian-general-catalyst-for-7point4-billion.html
WSJ https://www.wsj.com/finance/investing/janus-henderson-to-be-bought-by-trian-and-general-catalyst-for-7-4-billion-da2c19c3
MSN https://www.msn.com/en-us/money/taxes/janus-henderson-gets-7-2-billion-offer-from-trian-general-catalyst/ar-AA1PhiSY
is about three times that of the funds linked to by @msf."
I have a T-Bill maturing in early January.
The proceeds will be funneled into BBBIX.
BBBMX was previously held in a different account.
The difference is likely due to CLOs being invested in floating rate instruments while BBBIX is a traditional ultrashort bond fund. This mention of duration (and hence volatility) raises the question of risk.
Volatility is commonly used as a proxy for risk but they're not the same; at most volatility is just one aspect of risk. There is structural risk - how the portfolio is designed - what is the risk of it falling off a cliff? Instinctively that may be what some are wondering about with CLOs.
Yogi alluded to this in writing of CLOs as "battle-modified" and analogizing to mad cow disease, i.e. something that could affect an entire industry. In one sense, I agree with the concern that the CLOs may be building a Maginot line, preparing for the last "war".
That said, the financial industry seems to have done a pretty good job of protecting against another outbreak of mad cow disease. CDOs collapsed when subprime mortgages collapsed. CDOs were largely invested in a single sector. CLOs are not.
ConAgra doesn't just invest in beef (e.g. Hebrew National) but in corn (e.g. Orville Redenbacher) and a plethora of other foodstuffs. Similarly, https://content.naic.org/sites/default/files/capital-markets-primer-collateralized-loan-obligations.pdf
Diversification across multiple industries is not just fighting the last war, it's more generally a "Healthy Choice®".
Nevertheless, CLOs carry some risk of the unknown. Though they have added various safeguards to make the chance of a meltdown remote, it isn't zero. I view CLOs as a small step along the risk/reward trajectory. Slightly more risk than something like BBBIX with a modestly greater expected return.
Nice post!
My own feelings are that even if short term rates are pushed lower by a politically pressured Fed, longer term rates won't necessarily fall, could actually rise in response, and might yield appreciably more than the short end. That would actually drive down bond prices - hence the rate hedge. There is one "fly in the ointment" however. The Fed may seek to keep long term rates low by ramping up QE (buying longer dated bonds). In that case you'd be better off not hedging rates. It's all very confusing, but generally, I don't like to carry interest rate risk. Have enough other things that could go wrong without adding complexity. Hope my analysis makes sense.
I'm concerned about this as well.
Since the Fed's easing cycle began in 2024, long-term rates have actually gone up.
There is a high probability that the Fed will start QE again if long-term rates remain high.
The Fed ended quantitative tightening (QT) at the end of November
and then immediately increased new purchases of T-Bills.
The Return of QE
Interesting to see Fed & Treasury cooperation despite all of the tensions. Or, may be there is a story to be told in future.