Collateralised loan obligations, or CLOs, often get a bad rap. Many investors confuse them with mortgage-backed CDOs, the securitised debt vehicles that were pivotal in triggering the global financial crisis. But CLOs are backed by senior secured corporate loans, which fared meaningfully better during the GFC.
"CLOs typically offer higher yields than comparably rated corporate bonds. Plus, the high-quality tranches we focus on boast a default-free history, a period that includes the financial crisis," explains PGIM's Edwin Wilches, who believes CLOs warrant investor attention as a low-risk source of attractive income
Senior secured corporate loans represent the primary collateral in CLOs. The loans are pooled into a special purpose vehicle, which issues securities in tranches offering various levels of risk and return potential.
"The beauty of CLOs to a large degree is that you are able to customise, and investors can pursue their preference around what kind of risk-return they're looking to achieve," says Wilches.
CLOs as part of a fixed income allocation
More investors are now considering CLOs as part of their fixed income allocations. While approaches vary by risk appetite, there is a notable advantage in their ability to carry highly rated assets while benefitting from diversification.
Wilches uses the example of a CLO with AAA-rated debt. Though carrying the least amount of risk, the AAA tranche enjoys added protection from the CLO structure, which distributes payments from the underlying loan pool to the highest quality tranches first as part of a top-down "waterfall" hierarchy.
That means the AAA tranche is the first in line to receive principal repayment and interest income, and the last in line in terms of absorbing losses. In roughly three decades of CLO market history, there have been no reported defaults in the AAA and AA tranches.
High-quality CLOs boast a risk-return profile that can improve most fixed income allocations, with many investors employing CLOs in lieu of some short-term and/or investment grade exposure. In addition, amid increasing credit risk and lingering uncertainty, investor demand is rising as access expands. In fact, client requests were strong catalysts in helping inspire the creation of the PGIM Global AAA CLO Fund.
Read more about why now is an opportune time for CLOs in our Focus guide with PGIM.
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