CLOs: Well-Suited for Difficult Economic Times

This year has seen soaring inflation, rising rates, war in Ukraine and growing concern about a recession. How have CLOs weathered past periods of economic stress?

Collateralized loan obligations (CLOs) have not been immune to the volatility in the markets. That said, there is reason to believe the floating-rate nature of the asset class will help stabilize performance going forward, given the rising rate environment. It’s also worth noting that the CLO market has come a long way; it’s now a $1 trillion market, and one that is not easy for asset allocators to ignore in this environment.¹

Historically, CLOs have performed relatively well during times of stress. It’s important to remember the basics of CLOs—these are pools of loans that have seniority in the capital structure are ultra-diversified in the sense that they are not overexposed to one issuer or industry. For instance, one issuer typically makes up only about 50 basis points (bps) of the CLO, for instance, and any one industry, on average, tends to comprise 10% or less.²

In addition, CLOs are not mark-to-market vehicles. As such, while significant price moves occur and can be unnerving, in many cases they prove to be just noise, especially at the top of the capital structure. In fact, when markets are volatile, opportunities often arise for managers to take  advantage of that volatility by buying loans potentially at a discount—and that value accrues to the CLO’s debt and equity holders. Therefore, the fact that these structures are actively managed is important.

With the potential for a recession top of mind for many investors, it’s also worth looking at historical default rates. Of note, no AAA rated tranches have ever defaulted or experienced a principal impairment (Figure 1). Further down the capital structure, BBs, which are the lowest-rated tranche in a CLO capital structure, historically have had a default rate of less than 2%. S&P Global recently published a statistic that was also fairly compelling: they have rated over 16,000 CLO tranches since the 1990s, and only 50 of those have defaulted. Of those, 40 occurred before the 2008-09 financial crisis. Since then, the structures of CLOs have only gotten stronger; subordination has improved at every tranche level, and the collateral is higher-quality as well.

1. Source: J.P. Morgan. As of 2022.
2. Source: Based on Barings’ market observations.