How investors can use these high-yielding assets to diversify their portfolios

CNBC

a day ago

With interest rates still elevated, investors continue to find juicy yields in collateralized loan obligations. Some $4.7 trillion has flowed into CLO and bank loan exchange-traded funds since the start of the year, following 2024's record $25.6 billion in inflows , according to State Street. While investors fled the funds, along with many others, in April, the ETFs have bounced back. In May, $2 trillion in new money moved into bank loan and CLO ETFs, the ninth best month ever, State Street analyst Matthew Bartolini said in a May 31 note. CLOs are securitized pools of floating-rate loans to businesses and so their coupon payments shift alongside short-term interest rate changes. "That credit segment may continue to receive above-average inflows, given that sector's floating-rate profile and the Fed's 'wait-and-see' approach to rate cuts," Bartolini wrote. The Federal Reserve is set to meet on June 17-18 and is widely expected to hold interest rates steady, as it has been all year. Traders anticipate the next cut to come in September, according to the CME FedWatch Tool . Once the central bank starts to dial back rates, yields on CLOs are expected to gradually move down. Himani Trivedi, head of structured credit at Nuveen, said demand for the products has been steady up and down the capital structure, and expects that to continue. "There's not many floaters out there. So this has been a really good diversifier for investors," she said. "Given the volatility and potential for higher for longer, it still continues to see that flow come in, up and down the capital structure, for CLOs." Right now the Janus Henderson AAA CLO ETF (JAAA) has a 30-day SEC yield of 5.48% and a net expense ratio of 0.20%. It has $20.96 billion in assets under management as of Thursday. Some $4 billion has moved into the fund so far this year, according to FactSet. "With CLOs, you're getting a decent return," said John Kerschner, head of U.S. securitized products and a portfolio manager at Janus. "You're not taking outsized risk." JAAA YTD mountain Janus Henderson AAA CLO ETF year to date In fact, during the recent market dislocation, spreads on CLOs widened but had much less volatility than corporate credit or other parts of the bond market, he said. Liquidity was "incredible," he added. "It just showed that in these dislocations, instead of liquidity drying up, it actually gets better," Kerschner said. "There's more trading and that's what you want as an end investor." Picking up more yield Investors can pick up more yield as they move down in ratings, although those CLOs rated AAA are the first in line to get paid if the borrower declares bankruptcy. Nuveen launched its AA-BBB CLO ETF (NCLO) in December. It currently has a 6.4% 30-day SEC yield and 0.25% total expense ratio. It has collected $19 million in flows year to date, per FactSet, and has net assets of $89.4 million. NCLO YTD mountain Nuveen AA-BBB CLO ETF year to date While the ETF holds CLOs below AAA, they are still investment grade, Trivedi said. Assets with a rating of BBB- or higher by Standard & Poor's or Baa3 or better by Moody's, are considered investment grade and have a lower default risk compared to assets with lower ratings. Strong fundamentals have kept CLO defaults low, she noted. "They do provide a spread pick up, so where, even when the rates go down, you still have this additional carry," Trivedi said of those in the AA to BBB range. That carry is about 200 basis points over Secured Overnight Financing Rate (SOFR), which is the primary benchmark for CLOs, she added. "So even if SOFR was going down, against other fixed income instruments, you will get that extra credit spread for a minimal risk," she said. In addition, a recent analysis by VanEck found that over the past decade, A-rated CLOs outperformed AAA CLOs by 142 basis points a year. They also have lower volatility than investment-grade corporate bonds. BBB-rated CLOs topped AAAs by 147 basis points, the analysis found. The firm launched the VanEck AA-BBB CLO ETF (CLOB) last September. The fund invests primarily in the AA- to BB-rated tranches, has a 7.17% 30-day SEC yield and a 0.45% expense ratio. It has $116.39 million in total net assets, as of Thursday. Janus Henderson also has a lower-investment grade CLO product, the B-BBB CLO ETF (JBBB), launched in 2022. It has $1.33 billion in assets under management. The fund has seen outflows of $62 million year to date. CLOs in your portfolio While CLOs can be an attractive part of your income portfolio, investors should make sure they are diversified. When the Fed does start to cut rates, CLO yields will follow — and investors will need to make sure they also have some longer-dated bonds. Financial advisors and investment experts have been recommending intermediate-term duration assets for fixed-income investors. Janus Henderson's Kerschner likes to use AAA CLOs in more of a barbell approach, with the floating-rate assets on one end and longer duration agency mortgage-backed securities on the other. The firm's Mortgage-Backed Securities ETF (JMBS) has an effective duration of 7 years, a 5.11% 30-day SEC yield and 0.22% net expense ratio. That doesn't mean investors shouldn't have other assets in their fixed income portfolio, but he likes this barbell for at least over the next six to 12 months — and potentially longer. Nuveen sees CLOs as an excellent diversifier because they have a low correlation to most fixed-income assets. Because they are versatile, they can fill a variety of roles within the portfolio — including an alternative to short-duration bonds or a complement to high-yield bonds, the firm said in a rjecent note. Whether to stick with AAA-rated CLOs or the lower investment-grade assets depends on the investors time horizon, Trivedi explained. AAA-rated products can be seen more as a short-term cash investment, while the AA-BBB makes sense for a longer-term core investment, she said. "They can continue to get that coupon even when the rates go higher or lower," she said. "They're in a good safe spot."