IG CLOs can offer investors the benefits of spread pick-up and lower mark-to-market volatility, largely due to underlying collateral performance and structural security. But above all, manager selection is critical—even at the highest-rated tranches.
Investment grade-rated tranches of collateralized loan obligations (IG CLOs) can offer a compelling opportunity for investors to earn excess returns above and beyond what they are currently earning by holding investment grade credit. Since 2014—with the inception of the J.P. Morgan CLO Index (CLOIE)—the excess returns generated by IG CLOs have been achieved with less volatility than corporate credit. As we believe this trend is likely to continue, investors with allocations to IG credit and U.S. corporates may benefit from diversifying some of their exposure into IG CLOs.
What is driving this trend? A variety of factors have contributed—including the spread pick- up that investors can earn from holding IG CLOs versus comparably rated asset classes, as well as the lower overall volatility—both of which result from the performance of the underlying collateral and the structural security offered by CLOs. However, it’s not all market and structure related. Despite the common perception that manager differentiation is less important higher up in the capital structure, the ability to generate compelling risk- adjusted returns in the asset class is heavily influenced by manager selection decisions.
How IG CLOs Stack Up:
IG CLOs, as represented by the J.P. Morgan CLOIE, have historically offered similar absolute returns as U.S. IG corporates and U.S. credit. However, comparing the absolute returns of IG CLOs to those of IG credit is not a commensurable assessment, primarily because of the difference in the rate duration of these asset classes.
To remove the interest rate duration component from returns and focus solely on the credit component of the asset classes, we look at the excess returns of the Bloomberg Barclays U.S. Credit and U.S. IG Corporate indexes, as well as those of the Barings IG CLO Composite.
When assessing excess returns from January 2015 through August 2019, Barings’ IG CLO portfolios delivered cumulative excess returns of 9.50%, outperforming the Barclays U.S. Credit Index (5.90%) and Barclays U.S. Corporate Index (6.44%) by 360 bps and 306 bps, respectively.
In addition to generating higher excess returns, the Barings IG CLO Composite also experienced less volatility, contributing to a higher Sharpe Ratio (1.40) than the U.S. Credit Index (0.32) and the U.S. Corporate Index (0.34).