In recent years, the market for collateralized loan obligations (CLOs) has expanded from the realm of institutional finance into the hands of everyday investors. This is thanks to the emergence of CLO ETFs, which are drawing attention for their potential to deliver high-quality income with diversification and structural benefits.
To help meet this growing client need, the RBC iShares alliance recently expanded its suite to include RBC AAA CLO (CAD Hedged) ETF (TSX: RCLO). Mark Shohet, Portfolio Manager, Structured Credit & CLOs, on the BlueBay Fixed Income team, with RBC Global Asset Management (U.S.) Inc., and Stephen Hoffman, Managing Director, ETFs, RBC Global Asset Management Inc., discuss what advisors need to know.
What are CLOs?
Mark Shohet: A CLO is a vehicle that contains assets and liabilities. The assets are a pool of diversified senior secured corporate loans, which form the collateral of the CLO.
The liabilities are floating-rate debt instruments, or tranches, that are sold to investors to finance the purchase of those assets. Each of these tranches has different ratings (typically from AAA down to BB) and varying degrees of return and risk. These debt tranches pay investors different returns because of the risk of potential losses in the underlying collateral pool.
For example, the AAA tranche is paid first and has the highest protection of all the other tranches below it in the capital structure. Therefore, it’s the last to absorb any losses in the underlying collateral pool. The CLO is actively managed by a CLO manager.
A CLO ETF will purchase debt tranches from numerous CLOs to create an investment portfolio, similar to how a bond ETF will construct its portfolio.
Why are investors choosing to invest in CLOs?
MS: Investors are turning to CLOs because of the potential for high yields and excellent risk-adjusted returns. CLOs are also a way to provide diversification within an investor’s fixed income portfolio. These vehicles have continued to prove their resilience over the last couple of years through different market cycles, as they’ve weathered COVID, interest rate shocks, and macroeconomic volatility well.
What are the benefits of CLOs?
MS: First, there’s minimal credit risk in the investment grade part of the capital structure. Rate changes, tariffs, and other macroeconomic issues, as well as sector or idiosyncratic issuer risks, have nominal impact because there’s so much structural and collateral diversification embedded in these vehicles — there are hundreds of senior secured corporate loans underlying each CLO. In fact, over the last 30 years, no AAA tranche has ever defaulted.1
Second, CLOs are primarily floating-rate assets, meaning a CLO has no interest rate risk because the rates reset quarterly. So you don’t have that interest rate exposure you would have in fixed-rate assets.
Third, they offer attractive credit spreads and yields.
“Whether you’re a conservative or a growth investor, CLO ETFs are an attractive way to provide fixed income diversification.”
Which investors are best suited for CLO ETFs?
Stephen Hoffman: A CLO ETF can complement a core portfolio of stocks and bonds, or a high-quality, short interest-rate duration portfolio. Or, it can just be a stand-alone income-producing alternative asset class.
Whether you’re a conservative or a growth investor, CLO ETFs are an attractive way to provide fixed income diversification, as they fit within any type of risk profile. So they make sense in an income-focused portfolio. Given that a CLO ETF is a floating-rate product, investors can hold it either as a cash alternative or long-term diversifier.
How does RCLO compare to its competitors?
SH: Our investment management team, which Mark is a part of, has a long history of managing CLO portfolios, whereas some others are relatively new to this space. We are also focused on the liquidity of the underlying CLOs to ensure our ETF trades efficiently in the marketplace.
We have also hedged RCLO to the Canadian dollar. Because it invests primarily in the U.S., with some European exposure, having a hedge makes a lot of sense today with the Canadian dollar strengthening against the U.S. dollar.
MS: Also, at least 75% of RCLO’s investments must be AAA-rated CLO tranches (at the time of purchase), so we can be opportunistic with AA- and A-rated tranches. This is where active management comes in. We pay strong attention to best-in-class CLO issuers. And we utilize our relationships across both secondary and primary markets in the U.S. and Europe to access and trade within the portfolio, allowing us to generate income and create alpha for investors. Perhaps the biggest differentiator is that we’re also a CLO manager, managing seven deals in Europe and five in the U.S. So we have an in-depth understanding of the technicality and dynamics of the CLO market.
1 Source: Bloomberg, as of December 31, 2024. Over the 30-year history of CLOs, there have been zero defaults on AAA-rated tranches. Past default rates are not indicative of future default rates.
The RBC iShares alliance includes RBC ETFs managed by RBC Global Asset Management Inc. and iShares ETFs managed by BlackRock Asset Management Canada Limited (“BlackRock Canada”). Commissions, trailing commissions, management fees and expenses all may be associated with investing in exchange-traded funds (ETFs). Please read the relevant prospectus/ETF Facts before investing. ETFs are not guaranteed, their values change frequently, and past performance may not be repeated. ETF units are bought and sold at market price on a stock exchange and brokerage commissions will reduce returns. Index returns do not represent RBC ETF returns. RBC ETFs are managed by RBC Global Asset Management Inc., which is a member of the RBC GAM group of companies and an indirect wholly owned subsidiary of Royal Bank of Canada.
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