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The CLO (collateralized loans obligations) market, a long-standing investment vehicle for sophisticated investors, such as pension funds, global banks and sovereign wealth funds, is now seeing increased interest due to CLO ETFs. These ETFs bring the advantages of diversification and democratization to an asset class that exceeds $1.3 trillion in assets globally.1
The securitized bonds sector (of which CLOs are a part) represents approximately 25% of the fixed income universe today, larger than investment grade and high yield bonds combined.2
What are AAA CLOs?
A CLO is an investment vehicle that pools together a portfolio of loans and issues debt on that pool. A CLO manager creates and manages the CLO.
The debt issued by the CLO is backed by the pool of loans, with each tranche having different levels of seniority attached to it, ranging from the most secure AAA to the least secure equity (a tranche is a kind of segment within the CLO category). Yield and economic interest are higher but riskier on lower tranches, while yield is lower and more secure on the higher-rated AAA tranche.
Source: Morgan Stanley, Floating-Rate Loan Market Monitor.
However, to fully understand what a CLO is, you have to first understand what a floating-rate loan is.
Floating-rate loans are financial instruments used by companies, usually holding a first-lien position in the company's capital structure. These loans are secured by the company's assets and have the highest priority in terms of payment.
Loans are typically extended by a group or “syndicate”, often referred to as “broadly syndicated loans” (BSLs) when provided by a consortium of banks and loan investors. These loans are aimed at sub-investment-grade borrowers to support their financing needs.
Loans carry floating rate coupons usually based on SOFR (secured overnight financing rate) plus a specified credit spread.
The senior secured position of loans in the capital structure has led to low default rates and high recovery rates.
One of the largest floating-rate loans ETF in Canada is the Mackenzie Floating Rate Income ETF (MFT). Investors who want to learn more about the asset class can consult additional resources here.
Source: Mackenzie Investments, JP Morgan LCD, Morningstar LSTA US LL Index. As of January 31, 2025. *Par-weighted default rate.
Looking at the historical default and recovery rate over the past 24 years, it’s been 2.37% on average (skewed by 2009 numbers at around 9%).3
Looking at a typical CLO, the AAA tranche usually represents 65% of the capital structure. The net loss on the underlying pool of loans needs to be higher than 35% for this tranche to be impacted, hence its AAA rating.
A few metrics on the CLO market:4
A collateralized loan obligation (CLO) is typically a high-yielding floating rate instrument.
CLOs represent a US$1.3 trillion market, while the underlying floating rate loans represent a US$1.42 trillion market.5
There are more than 1,000 loan issuers and currently 1,300 loans in circulation.
A typical size for a CLO is US$450 million, comprised of approximately 150 loans (with an average B+ credit rating). It requires a lot of credit.
CLO managers create CLOs and there are approximately 158 US-based CLO managers in the world,1
CLOs offer attractive features for investors, such as:
- Higher income: the yield adjusts in tandem with short-term interest rates.
- Capital preservation: AAA CLOs have seniority in the capital structure.
How do CLOs work?
When a CLO is initially established, it raises funds to acquire a portfolio of loans by selling different debt and equity tranches to investors, ranging from AAA to equity. Each tranche has a distinct claim priority on the cash flows from the loan pool and varying levels of exposure to losses from the underlying collateral. Cash flow distributions start with the most senior debt tranches in the CLO capital structure (AAA) and proceed down to the junior equity tranche, following a distribution method known as a waterfall.
The cash flow waterfall, along with performance tests and collateral concentration limits, offer varying degrees of protection to the CLO's debt tranches. The most senior and highest-rated AAA tranche carries the lowest coupon but has the highest claim on cash flow distributions and is the most remote from losses. Senior AAA tranches have the first claim on cash flows and benefit from the credit support of subordinate tranches, which absorb potential losses first. Additionally, AAA tranches benefit from structural protections: the CLO manager conducts performance tests on the loan portfolio to identify any deterioration in the underlying collateral. If these tests are triggered, the CLO manager redirects cash flows from lower tranches to pay higher tranches first.
The combination of the underlying seniority of loans, their low default and high recovery rate, as well as the CLO structure have resulted in zero losses in AAA CLOs since they’ve existed.6
Mezzanine tranches offer higher coupons but come with greater exposure to loss and lower ratings. The equity tranche, the most junior and riskiest part of the CLO capital structure, is neither rated nor coupon-bearing. Instead, it represents a claim on any excess cash flows remaining after all debt tranche obligations are fulfilled. AAA senior tranches are the largest, typically making up 70% of the capital structure. Mezzanine tranches rated AA to BB each represent about 4–12% of the CLO capital structure. Equity tranches generally constitute around 8-10% of the capital structure.7
Is it 2008? Addressing myths around securitized debt instruments
Some investors may be associating securitization with the 2008 global financial crisis. While securitized instruments certainly played a part, the root of the problem came from what was securitized.
The main issue was that some collateralized debt obligations (CDOs) were based off subprime mortgages and delinquent lending.
There are crucial differences between CLOs and CDOs:
CDOs |
CLOs |
|
Underlying assets |
Typically include a variety of debt instruments, such as bonds, mortgages (including subprime mortgages) and even other CDOs. |
Focus exclusively on leveraged loans, which are first lien senior secured corporate loans. |
Managed |
Static pool. |
Actively managed. |
Risk and return profiles |
Often had higher risk, due to the inclusion of subprime mortgages and other lower-quality assets, which contributed to their poor performance during the global financial crisis |
Have built-in risk protections and invest in higher-quality assets, resulting in better performance even during periods of market stress. |
Transparency |
Were often opaque, making it difficult for investors to understand the underlying assets and risks. |
Are generally more transparent, allowing investors to look through to the underlying loans and perform credit analysis. |
CLOs are based off senior secured loans with low default rates and high recovery rates.
Although AAA CLOs had zero default during the great financial crisis, rules have been strengthened since. Here are some notable differences:
- Rating agencies now require that CLOs carry more overcollateralization.
- CLOs are now collateralized almost exclusively by senior secured loans.
- Documentation is more investor friendly due to CLO managers shortening the trading period.
This should be a reminder for investors to understand the structure they are investing through, but even more importantly, to carry out thorough due diligence on the underlying assets to which they are exposed.
In conclusion, what are AAA CLO ETFs?
AAA CLO ETFs are ETFs providing exposure to a basket of CLOs (between 80 to 1000 typically), with each one providing exposure to the AAA tranche of a pool of underlying loans (between 150-200 typically).
The ETF structure allows for intraday liquidity, diversification and ease of access to a sophisticated market otherwise not easily accessible to individual investors.
AAA CLO ETFs have garnered tens of billions of investor assets over the past few years, as their main features (being AAA rated, a high relative yield and low interest-rate risk) and track record attracted more attention from a larger investor base than the historic institutional target market.
Stay tuned for the launch of the Mackenzie AAA CLO ETF (MAAA) at the end of April 2025.
Sources:
1 Source: UBS, Bloomberg, BofA Global Research, as of December 31, 2024.
2 Busting the bias against U.S. securitized - Janus Henderson Investors, US Investor.
3 Source: Mackenzie Investments, as of February 28, 2025.
4 Source: Mackenzie Investments.
5 Source: Morgan Stanley, Floating-Rate Loan Market Monitor.
6 Source: S&P Global, “Default, transition and recovery. 2022 Annual Global Leveraged Loan and CLO Default and rating transition study” May 26, 2023.
7 Source: Guggenheim, “Understanding Collateralized Loans Obligations”.
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