Retail investors can now access the diversification and income benefits of CLOs.Getty Images
A new type of exchange-traded fund (ETF) might be relatively unknown to many Canadian investors, but the potential benefits are likely worthy of attention, says Mark Jarosz, head of credit alternatives at BMO Global Asset Management.
In the past few months, a handful of ETFs have launched in Canada, offering exposure to collateralized loan obligations (CLOs).
“Institutional investors have long used CLOs to diversify their fixed-income sleeve of their portfolios for steady yields – higher than treasuries and even investment-grade bonds in some instances. Now with CLO ETFs, retail investors can get exposure too,” Mr. Jarosz says.
CLO ETFs are a novel tool for Canadians seeking high-quality, superior yields to complement their diversified portfolios. With new offerings entering the market, what are the benefits of CLOs and how can you navigate the opportunities to unlock this new income stream?
Corporate loans have a strong record
CLOs contain corporate loans, which have a long track record of low defaults. This is in contrast with CDOs—collateralized debt obligations—many of which that were packed with high-risk subprime mortgages that helped spark the 2008 financial crisis.
Even during times of market stress, CLOs have provided steady income streams. The challenge for most investors has long been getting in on them.
CLOs were previously the domain of institutional investors. Investing directly in CLOs required a minimum of $100-million in assets. About five years ago, the first CLO ETF launched in the United States, gathering US$20-billion in assets in five years.
CLO ETFs have democratized access to retail investors. While these alternative assets had high barriers to entry, they’re now tradeable on exchanges with no price obstacles and intraday liquidity.
CLOs structures reduce the risk
The asset-backed securities consist of layered tranches of hundreds of loans to U.S companies of varying risk. The debt obligations have varying seniority in the cash flow waterfall. The AAA tranche is the most senior and therefore the most stable. It has priority access to interest and principal payments over other debt obligations. AAA often makes up 65 per cent of the typical CLO.
With each layer underneath, risk increases, although other tranches comprise a much smaller percentage of the average CLO. At the bottom is the higher-risk tranche—the equity component. This provides the highest reward though it bears potential losses first.
Altogether, the tranches make CLOs extremely diversified. And CLO ETFs offer even greater diversification, Mr. Jarosz adds.
“As an ETF manager, I can build a portfolio with dozens of CLOs diversified across geography, sector and industry, providing exposure to more than 10,000 loans.”
Equally notable, investors receive yields higher than treasuries and even investment-grade bonds. The underlying loans also have floating interest rates, meaning investors earn more in rising rate environments.
“In a declining rate environment, these will continue to perform well as the credit risk decreases for the underlying loans,” says Mr. Jarosz.
Finding the right fit
When deciding on investing in a CLO ETF, consider the management fees, bid-ask spreads (the difference between the ask price and the bid price for an asset), the managers’ experience and strategy, and the underlying CLO holdings.
Among the Canadian-listed ETFs is BMO’s suite: the BMO AAA CLO ETF-CDN ZAAA-NE, the BMO AAA CLO ETF-USD units ZAAA.U-NE, and the BMO AAA CLO ETF-CDN, currency hedged ZAAA.F-NE.
Notably, BMO’s CLO AAA ETF series offers exceptional stability and security, holding only the AAA tranches, which are highly liquid, trading frequently on the over-the-counter market.
The AAA tranches are among the most secure of all corporate fixed income tranches, having never experienced default. That is a reflection of the innovative design of CLOs, whereby lower rated tranches must suffer significant losses before affecting AAA tranches.
“CLOs have built-in guardrails that protect the AAA tranche,” Mr. Jarosz says.
Mr. Jarosz has spent most of his career in structured credit and he has deep experience analyzing CLOs. While these products are newer, they should be on investors’ radars, he says. They offer exposure to an alternative asset class in an ETF wrapper, which would be challenging to access otherwise.
“Given the historical performance and resilience of this market, many Canadian investors should give these ETFs a closer look.”
This article has been sponsored by BMO Global Asset Management.
BMO Global Asset Management is a brand name under which BMO Asset Management Inc. and BMO Investments Inc. operate.
CLOs are floating- or fixed-rate debt securities issued in different tranches, with varying degrees of risk, by trusts or other special purpose vehicles (“CLO Issuers”) and backed by an underlying portfolio consisting primarily of below investment grade corporate loans. The BMO ETF pursues its investment objective by investing, under normal circumstances, at least 85% of its net assets in CLOs that, at the time of purchase, are rated AAA or the equivalent by a nationally recognized statistical rating organization.
AAA herein refers to the order of payments, should there be any defaults, and does not represent the ratings of the underlying loans within the CLO. If there are loan defaults or the CLO Issuer’s collateral otherwise underperforms, scheduled payments to senior tranches take precedence over those of mezzanine tranches (a tranche or tranches subordinated to the senior tranche), and scheduled payments to mezzanine tranches take precedence over those to subordinated/equity tranches. The riskiest portion is the “Equity” tranche, which bears the first losses and is expected to bear all or the bulk of defaults from the corporate loans held by the CLO Issuer serves to protect the other, more senior tranches from default.
Commissions, management fees and expenses all may be associated with investments in exchange-traded funds. Please read the ETF Facts or prospectus of the BMO ETFs before investing. Exchange-traded funds are not guaranteed, their values change frequently and past performance may not be repeated.
For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the BMO ETF’s prospectus. BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.
BMO ETFs are managed and administered by BMO Asset Management Inc., an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal.
Advertising feature produced by Globe Content Studio with BMO Global Asset Management. The Globe’s editorial department was not involved.