The alternative: AAA CLOs

Following an incredible 2023, collateralised loan obligation (CLO)  investors are again having a great year with the asset class outperforming the more traditional asset classes. Spreads have tightened across the board, and especially sub-investment grade (IG) bonds have rallied significantly. But, there is one part of the market that we think is somewhat underappreciated, AAAs. For many traditional credit investors, CLOs are still a product that they don’t really know and deemed to be illiquid. We would argue that AAA CLOs are now a great alternative to euro IG corporate bonds in particular, especially now that the European Central Bank (ECB) is no longer buying bonds!

The AAA CLO market has proven itself by now, both in terms of credit, with no losses through the last three decades, and liquidity has been thoroughly tested post the UK mini-budget, where UK pension funds were forced to sell very large volumes of AAA CLOs as a large floating rate allocation. In the same period after Covid, AAA CLOs delivered investors what it said on the tin, at a fraction of the volatility that we’ve seen in IG corporate bonds. The Global AAA CLO market has grown to a good size now, standing at around $700bn (with a further $500bn in the non-AAA CLO market), so that helps liquidity, especially as a lot of investors invest in both US and euro CLOs.

Unlike the sterling market, euro corporate bonds have got less duration and therefore it’s a very different allocation for many investors. The Euro Non-Fin Index has an average rating of BBB+, a duration of five years and a yield of 3.8%. As many of these bonds originated some years back, the actual coupon income is only 2.1% for the index. AAA euro CLOs currently yield around 4.4%, but have an average current coupon of 5.1%. Now this is where things get interesting, CLOs are floating rate and the coupon tracks Euro Interbank Offered Rate (Euribor). Currently the rate market is forecasting the ECB to cut rates first and for the ECB rate to reach 2.7% in two years. That’s the reason why the current AAA CLO yield is “only” 4.4%, we price CLOs over an implied forward curve so we can compare apples to apples.

Below we have plotted this “forward” yield for both AAA CLOs and corporate bonds and you can see that they closely track each other, especially during the peak of Quantitative Easing, which highly benefited corporate bond investors with the ECB being the biggest buyer in town. Since then, the correlation is still there but euro corporate bonds still trade inside AAA-rated CLOs, AAA CLO spreads have lagged credit as it is a more specialist asset class that tends to be overlooked by traditional credit investors. There are a few dynamics in the CLO market that I think make CLOs the more interesting allocation currently. First of all, loan amortisations have picked up significantly so bonds are getting shorter, as most still trade at a discount there is some performance to lock in. Secondly, we’re seeing an increasing demand for the product, and part of that is coming from the Japanese banks. Japanese banks were one of the largest buyers in the market between 2016 and 2018, which was also the time that CLOs yielded less than corporates. As yields to maturity are assuming no car crashes along the way, we are seeing more “idiosyncratic stories” play out in corporates, and in AAA CLOs you are much better protected. And last but not least, if the ECB fails to deliver (if they get nervous to act before the FED for example…) this will benefit CLO investors as the current coupon will stay higher for longer.

In our funds, we have favoured short AAAs as well as primary AAAs at Euribor + 1.5% of yield, over both IG euro corporates and A/BBB-rated asset-backed securities (ABS) as AAA CLO spreads seem to be lagging the incredibly strong technical that we’re seeing in those two markets, and with AAAs, we know we get plenty of liquidity and that gives us the flexibility in the funds that we’re looking for in the current macro environment, while enjoying a healthy 5% coupon euro income in the meantime.

Source: TwentyFour, Citi Velocity, BofA, ICE indices, Bloomberg - 2 May 2024