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By Hitesh Patel - May 30, 2018
As interest rates continue to rise and chip away at bond returns, investors may want to look beyond traditional fixed-income holdings. Rising rates are generally seen as a negative for bond investors because of their inverse relationship—as rates rise, traditional bond prices fall.
One alternative in a rising rate environment: Collateralized Loan Obligations (CLOs). CLOs are designed to take an overall pool of loan debt (typically, commercial loans extended to businesses), divide it into investable pieces, and redistribute the cash flow to investors. Because the loans they invest in feature floating-rate yields, which increase as interest rates rise, they may not directly suffer the same adverse effects from rising rates as traditional fixed-income investments.
CLOs' complex structure has historically acted as a barrier to investment, and they've not typically been available to individual investors. Get past the complexity, though, and we believe CLOs may offer return potential during rising rates. They have had attractive performance in similar past rising-rate environments and have had a low default rate.
A CLO is a type of structured credit instrument, which is a general term to describe an alternative investment that combines debt into a single vehicle. While other types of structured credit may pool together mortgages or bonds, for example, each CLO represents a basket of individual underlying commercial loans.
CLOs primarily purchase senior secured bank loans, which are commercial loans extended to businesses generally rated below investment grade. Businesses use these loans to:
Although the loans are made to companies below investment grade (typically with BB or B credit ratings), they are structured to offer specific investor protections. For example, the loans are secured by the borrower's assets. Accordingly, they are considered "first-lien" bank loans, meaning they are among the first claims to be repaid to lenders (investors) if the company files bankruptcy.
To fund the purchase of the underlying loans, CLOs generally issue asset-backed securities (ABS) divided into separate "tranches." Each tranche represents a specific level of risk/reward potential. Investors purchase the tranche that aligns with their objectives (more aggressive, high risk and reward potential, or more conservative, low risk and reward). In return, they receive cash flows from any payments on the underlying loans.
Each CLO tranche has a different risk and return profile based on its cash flow claim priority (see chart above). Distributions begin with the most senior debt tranches—those with the highest priority claim—and flow down to the bottom equity tranche, known as a waterfall.
The top tranches get paid first but have lower return potential and offer lower yields. The bottom tranches have a higher return potential and offer higher yields, but because they're paid last, the risk of negative returns is higher.
CLOs may be attractive investments for investors concerned about investing in bonds during a period of rising interest rates. The loans that CLOs purchase have floating interest rates, meaning their yields move up—or down—along with prevailing interest rates.
The floating-rate feature is particularly attractive to investors who anticipate a continued rise in interest rates. The Federal Reserve (Fed) is expected to raise short-term rates at least two more times in 2018, which could potentially harm other credit instruments but benefit bank loans and CLOs. Senior bank loans have historically outperformed other credit investments, such as high-yield bonds and investment-grade bonds, in various rising-rate periods.
Additionally, the diversification inherent in a CLO may help reduce the risk of default from a single loan or the decline of a particular sector. A CLO is usually diversified among 100 to 225 bank loan issuers, so any one issuer makes up less than 1 percent of the CLO, on average. The CLO portfolio is also generally diversified across multiple sectors and industries.
While CLOs have historically performed well, they are not without risk, emphasizing the need for skilled professional and active management. Their complexity also makes CLOs difficult to navigate for the average investor.
Strong recent demand for CLO debt from investors seeking higher yields than are typically available from U.S. Treasuries and other high-quality bonds has made CLOs somewhat expensive. However, this is consistent with other higher-yielding securities, including corporate bonds.
Investor demand for yield has also led to an increase in lower-quality loans. Certain loans lack some of the usual protections typically found in more traditional credit securities, and this type of debt now makes up a large proportion of collateral for CLOs.
CLOs offer attractive return potential in a variety of market environments, but we believe they may be particularly well suited for today's current climate of rising interest rates. They've also had strong historical performance, resilience over credit cycles, and a track record of low defaults.
We believe the performance potential and attractive investment characteristics of CLOs may present opportunities for investors seeking to enhance their income potential in the current environment. But given the complexity of the CLO structure, we believe professional, active management is paramount.
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Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Alternative mutual funds that hold a variety of non-traditional investments also often employ more complex trading strategies than traditional mutual funds. Each of these different alternative asset classes and investment strategies have unique risks making them more suitable for investors with an above average tolerance for risk.
Diversification does not assure a profit nor does it protect against loss of principal.
Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.