CLO Liabilities: Carry, Diversification and Mitigating Default Risk for Credit Portfolios

The market has reached a consensus: Interest rate cuts are coming this year from the U.S. Federal Reserve and European Central Bank, and many market participants are thinking about how to add duration to their portfolios ahead of those cuts.

But what if rate cuts take longer than expected or are less substantial than expected? Today, leveraged credit investors are getting significantly higher yields from leveraged loans than high yield bonds at 9.8% compared to 8%. Every day rates remain at current levels, an investor who moved into high yield would leave the extra income they could have earned in leveraged loans on the table.

A common way to hedge this risk is to follow a barbell approach, with exposure to high yield bonds, which tend to have fixed interest rates and typically outperform when interest rates are falling, on one side and leveraged loans, which have floating interest rates, on the other. Over the last few months, we have been reducing our own overweight to leveraged loans and increasing exposure to high yield when entry points have looked attractive to lock in fixed interest rates.

We think another solution is to add collateralized loan obligation (CLO) debt to the liquid portion of a credit portfolio. These floating-rate securities offer attractive carry that can help hedge against the potential for slower or lesser rate cuts, offer a degree of protection in the form of par subordination, and add a source of diversification to a liquid credit portfolio.

Relative Value in CLO Debt

CLOs are special-purpose vehicles created to invest in diversified portfolios of leveraged loans. They fund those investments by issuing securities that investors with a range of risk-and-return profiles can purchase. While all the leveraged loans that make up a CLO are rated below investment grade, CLOs issue AAA-rated securities that banks and financial institutions with conservative risk mandates can access. Investors with higher risk tolerance, such as hedge funds, family offices and sovereign wealth funds, can obtain access to unrated equity tranches with much higher return potential. CLO debt generally refers to tranches rated from AAA to B.

CLO debt offers superior carry compared to other liquid credit assets. Exhibit 1 shows that BB-rated CLO debt tranches offer both higher spreads than B-rated loans and a yield pick-up relative to high yield bonds. In this way, CLO debt not only rounds out the floating-rate side of the barbell to hedge against the risk that rates stay higher for longer, but also helps investors make up for some of the yield they may forego in adding duration.

EXHIBIT 1: BB-Rated Clo Assets Offer a Compelling Carry Pick-Up Compared to Similarly Rated Leveraged Loans And High Yield Bonds

Structural Protection: Par Subordination Explained

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.

Here's how it works: CLO equity, which comprises the bottom 10% of a typical CLO structure, is the riskiest portion of the structure and absorbs the first losses in the portfolio. Thus, if 10% of leveraged loans in a hypothetical CLO portfolio were to default, only the equity tranche would be impaired, even if the underlying loans were a total loss, with no recovery whatsoever. As cumulative defaults continued to rise, B- or BB-rated tranches would be impacted next, and so on up the CLO capital structure. Debt rated AAA would be the last to absorb losses and therefore the least risky portion of the structure.

It is partly as a result of this subordination, along with structural changes intended to minimize losses, that BBB-rated CLO tranches issued since the Global Financial Crisis have largely avoided defaults. As Exhibit 2 shows, the nearly 7,000 AAA-rated CLO debt tranches issued between 1993 and 2022 had zero defaults, and even the lowest rated debt tranche had only a 1.8% default rate.

EXHIBIT 2: Total Defaults by CLO Tranche

CLOs as a Diversifier

KKR’s Global Macro and Asset Allocation team has noted that as correlations between the performance of publicly traded stocks and bonds has increased, the 60/40 portfolio allocation is more susceptible to excess market volatility now than ever before. It stands to reason that assets with low correlations to standard stocks and bonds are key to achieving investors’ return targets and mitigating risk.

CLO debt can be an effective way to add an element of diversification to a liquid credit portfolio, in our view. Exhibit 3 shows that CLO debt has very low correlations with U.S. Treasuries and only moderate correlations with high yield bonds, particularly the higher-rated bonds. While the correlations between CLOs and leveraged loans are slightly more elevated, they are lower than those between high yield bonds and leveraged loans.

EXHIBIT 3: CLO Debt Correlation with Other Asset Classes

Conclusion

Investors are understandably trying to position their portfolios for interest rate cuts after a long period of high inflation and a rapid succession of rate hikes. A barbell approach, with exposure to duration on one side and floating interest rates on the other side, just in case rate cuts don’t come in as expected, is the approach that many are taking.

Many investors we speak with are trying to figure out the right weighting of leveraged loans on one side of the barbell and high yield bonds on the other. However, we think it also makes sense to supplement the leveraged loan allocation with CLO debt, which offers superior carry on a risk-adjusted basis, important protection against defaults, and diversification potential.