BBB-rated collateralised loan obligations (CLOs) have “emerged as another subsector to consider”, alongside high yield and leveraged loans, for investors seeking higher income, according to Janus Henderson Investors.

In a new research note, the firm said the inclusion of BBB CLOs in portfolios “may help improve risk-adjusted returns” due to their higher credit ratings, lower historical defaults, low correlation, and higher historical total returns versus high yield and leveraged loans.

Read more: Janus Henderson: CLO sector outperformance is “no outlier”

BBB-rated CLOs have historically exhibited very low default rates, with only one default since 2007.

“Primarily, the lower default rate is due to the credit enhancement feature within the CLO structure, where losses are borne first by the lowest-rated tranches, moving up to higher-rated tranches as defaults increase,” wrote Janus Henderson Investors portfolio managers John P. Kerschner, Nick Childs, Jessica Shill, and Denis Struc.

“In a typical CLO structure, the BBB tranche will not suffer any losses until defaults rise above 10 per cent. As a result, most losses have historically been absorbed by lower-rated tranches.”

However, investors should be prepared for potentially higher volatility within the BBB CLO sector and less liquidity than high yield and leveraged loans, they warned.

Kerschner, Childs, Shill and Struc also noted that BBB CLOs have “experienced similar, or at times larger, drawdowns” than high yield and leveraged loans.

They pointed to data which showed that BBB CLOs recorded the highest average drawdown at -11.6 per cent, followed by high yield (-9.7 per cent) and leveraged loans (-6.7 per cent) in the four most recent market drawdowns, with BBB CLOs having sold off “aggressively” during the Covid pandemic.

Excluding Covid, high yield and BBB CLOs experienced similar average maximum drawdowns, at around 8.7 per cent and 8.4 per cent, respectively.

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The portfolio managers suggested that higher drawdowns within BBB CLOs “are not necessarily indicative of an increase in CLO defaults during times of market stress”, and that their volatility is, instead, more closely linked to cash-raising trades and the risk of downgrades.

“During flights to safety, money managers may look to liquidate assets that are easiest to move, such as short-duration bonds and floating-rate CLOs,” Kerschner, Childs, Shill and Struck said. 

“Rating agencies tend to downgrade BBB CLOs when their credit enhancement deteriorates, which can happen en masse in a dislocation such as Covid. In contrast, downgrades in high yield and leveraged loans have tended to be more idiosyncratic, or name-specific. While downgrades to BBB CLOs do not affect their cash flows to investors, the prices of the bonds adjust lower to reflect the lower rating, and this contributes to price volatility.”

The portfolio managers also observed that, despite their higher volatility, BBB CLOs have moved in a less-correlated manner compared to high yield and leveraged loans, adding that this “may dampen the potential adverse impact of its higher volatility within a diversified bond allocation”.

Kerschner, Childs, Shill and Struc concluded that “with the right approach to navigating market selloffs and maintaining a total portfolio perspective”, the volatility risks associated with BBB-rated CLOs can be “managed and mitigated”, making them “a compelling option” for portfolios.

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