Animal Spirits Podcast Episode Summary
Title: Talk Your Book: Floating Rate Income
Host: Michael Batnik and Ben Carlson
Guests: Fran Rodolasso (Head of Fixed Income ETF Portfolio Management, Vaneck) and Bill Sokol (VP and Director of Product Management, Vaneck)
Release Date: March 31, 2025
Introduction to Collateralized Loan Obligations (CLOs)
In this episode, Michael Batnik and Ben Carlson delve into the intricacies of Collateralized Loan Obligations (CLOs) with their guests from Vaneck. Unlike the Collateralized Debt Obligations (CDOs) that played a pivotal role in the 2008 financial crisis, CLOs represent a more refined and resilient financial instrument.
Michael Batnik [03:23]: “Collateralized loan obligation. Not exactly a corporate bond or a treasury bond. What is a collateralized loan obligation?”
Fran Rodolasso explains that CLOs are “a securitized portfolio of leveraged loans, often referred to as bank loans or syndicated loans,” which are secured by the assets of cash flow-generating companies. These loans are senior to other debts, such as high-yield bonds, historically resulting in lower loss levels.
Structure and Function of CLOs
CLOs are structured into various tranches, each with different levels of risk and return:
- Senior Tranches (AAA, AA): These receive payments first and are the most insulated from losses.
- Mezzanine Tranches (A, BBB): These absorb losses before the senior tranches.
- Equity Tranche: This absorbs the first losses and receives excess cash flows after all debt holders are paid.
CLOs pay floating rates of interest, typically SOFR plus a fixed spread, aligning with the floating rate nature of the underlying loans.
Fran Rodolasso [03:51]: “A CLO typically holds 150 to 300 of these individual loans. ... they pay floating rates of interest, so you're going to get SOFR plus a fixed spread...”
The Rise of CLOI ETF
Vaneck's CLOI ETF has experienced remarkable growth, scaling from zero to over a billion dollars in just three years. This surge underscores a significant demand for floating rate income products amidst volatile bond markets.
Michael Batnik [01:12]: “...CLOI, which is a collateralized loan obligation ETF, which is obviously making way in the headspace of investors because this thing went from zero to a billion in like the last three years, I guess. Unbelievable.”
Ben Carlson attributes this growth to the ETF's ability to offer higher yields, diversification benefits, and resilience during rate volatility.
Ben Carlson [08:58]: “...a combination of risk, return, and diversification.”
Benefits of Investing in CLOs
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Floating Rate Advantage: CLOs adjust interest rates in line with market rates, offering protection against rising rates and inflation.
Michael Batnik [02:14]: “...it's floating rate. So yeah, when rates go up and inflation goes up, this thing, the rates adjust...”
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High Sharpe Ratios: CLOs have delivered better returns with lower volatility compared to traditional fixed income assets.
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Diversification: CLOs offer diversification benefits as they are not highly correlated with other fixed income instruments like Treasuries or investment-grade bonds.
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Low Default Risk: Investment-grade CLO tranches have shown minimal default rates, making them a safer alternative within the credit spectrum.
Ben Carlson [09:44]: “...AO Sharpe ratios. They have better returns than investment grade credit with lower volatility...”
Risks Associated with CLOs
While CLOs offer numerous benefits, they come with inherent risks:
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Spread Risk: The primary risk is the widening of credit spreads, which can lead to price volatility in the ETF.
Fran Rodolasso [09:57]: “The main risk here is that you have a credit event that spreads widen out and you're going to see that reflected in the price...”
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Credit Events: Although defaults are rare in investment-grade CLO tranches, lower-rated tranches (BBB and below) can experience significant drawdowns during economic downturns.
Ben Carlson [21:02]: “...high yield tranche of double Bs maybe start trading down into the mid to low 80s in terms of cents on the dollar...”
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Complexity: CLOs are complex financial instruments, requiring a thorough understanding to navigate effectively.
Fran Rodolasso [34:28]: “There's just the complexity ... and the volatility, the spread risk.”
Investment Strategy and Process
Vaneck employs a dual approach combining both top-down and bottom-up analyses:
- Top-Down: Assessing macroeconomic factors to determine relative positioning within the CLO capital structure.
- Bottom-Up: Detailed analysis of individual loans, diversification mandates, and manager performance.
Sub-Advisor Role: Pinebridge Investments, Vaneck's sub-advisor, plays a crucial role in credit selection and portfolio construction, ensuring adherence to diversification and risk management protocols.
Ben Carlson [23:09]: “...there's a big bottom-up component. ... there's a tiering of managers that's one risk but another sort of bottom up analysis...”
Performance and Market Resilience
Since its launch in June 2022, CLOI has withstood market volatility, particularly benefiting from the floating rate structure during the bond bear market. The ETF has maintained a maximum drawdown of approximately 3%, signaling its resilience.
Ben Carlson [13:33]: “...even down to the single A, there is a lot of liquidity... but Mike, you already made the point.”
Historical Context: CLOs have successfully navigated previous financial crises, maintaining minimal default rates and demonstrating robust performance over decades.
Ben Carlson [26:41]: “The ETFs didn't exist in 2020, but ... during 2020, the broad CLO index behaved more like investment grade corporates, which was still a very significant drawdown for that brief period.”
Incorporating CLOs into Investment Portfolios
CLOs can serve as a strategic component within both investment-grade and high-yield portfolios:
- Investment Grade Investors: Can allocate to AAA to BBB tranches for enhanced yields without substantial additional risk.
- High Yield Investors: Lower tranches (below AAA) offer higher yields with increased volatility, complementing existing high-yield allocations.
Fran Rodolasso [28:12]: “...any exposure would have helped in a fixed income portfolio over the last decade...”
Investor Base and Adoption
The primary investors in CLO ETFs like CLOI are advisors, Registered Investment Advisors (RIAs), and insurance companies. These entities appreciate the liquidity and diversification CLO ETFs offer, alongside the higher yields compared to traditional fixed income products.
Fran Rodolasso [31:37]: “...most of the inflows coming from advisors, typically RIAs... insurance companies have historically been very big investors in CLOs...”
Addressing Common Questions and Concerns
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Comparison to 2008 CDOs:
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Ben Carlson emphasizes that CLOs are fundamentally different from the CDOs that caused the 2008 crisis. Modern CLO structures are more robust with better subordination and diversification.
Ben Carlson [32:51]: “...that's why we've got a pretty chart that says no. Those were other types of collateralized debt obligations in the subprime mortgage sector...”
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Volatility and Loss Potential:
- While higher-rated tranches exhibit low volatility, lower tranches can experience significant price swings during economic stress, though permanent losses remain minimal.
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Complexity of Investment:
- Investors must understand the structural complexities and spread risks inherent in CLOs. Vaneck offers educational resources such as blogs, white papers, and webinars to assist investors.
Conclusion and Final Insights
The episode concludes with a reaffirmation of CLOs as a valuable addition to diversified investment portfolios, offering higher yields, floating rate advantages, and robust risk-adjusted returns. The guests from Vaneck encourage interested advisors to explore educational materials and engage with Vaneck’s resources for a deeper understanding of CLO investments.
Michael Batnik [36:04]: “Thank you to Fran and Bill. Remember, check out vaneck.com to learn more.”
Notable Quotes
- Fran Rodolasso [03:51]: “A CLO typically holds 150 to 300 of these individual loans...”
- Ben Carlson [08:58]: “It's a combination of risk, return, and diversification.”
- Fran Rodolasso [09:57]: “The main risk here is that you have a credit event that spreads widen out...”
- Ben Carlson [23:09]: “There's a big bottom-up component...”
- Michael Batnik [02:14]: “...it's floating rate. So yeah, when rates go up and inflation goes up, this thing, the rates adjust...”
- Ben Carlson [32:51]: “...those were other types of collateralized debt obligations in the subprime mortgage sector...”
Additional Resources
For those interested in learning more about CLOs and Vaneck’s offerings:
- Website: vanak.com
- Educational Content: Blogs, white papers, webinars available on Vaneck’s website.
- Contact: Email at animalspirits@compoundnews.com
This comprehensive discussion provides valuable insights into CLOs and their role in modern investment strategies, highlighting their benefits, risks, and operational mechanics. Whether you're an institutional investor or an advisor seeking diversification and enhanced yields, CLOs present a compelling option within the fixed income landscape.