Collateralized Loan Obligations (CLOs) have been a significant part of the fixed income landscape for over two decades, with the first CLOs issued in the 1990s. Today, the CLO market is valued at approximately a trillion dollars, according to Edwin Wilches, Managing Director and Co-Head of Securitized Products at PGIM Fixed Income. Traditionally considered an institutional-only investment, the advent of the ETF wrapper has played a crucial role in the democratization of CLO access, allowing retail and smaller institutional investors to participate. Bryan Whalen, Chief Investment Officer & Portfolio Manager at TCW, emphasizes that the ETF wrapper allows individual and small institutional investors, who typically lack the resources or time to properly underwrite the complex CLO asset class, to gain exposure by outsourcing the underwriting to managers. This discussion took place at the 2025 Morningstar Investment Conference, specifically on the "ETFs and CLOs: Risks and Opportunities" panel, which included Paul Olmsted, Senior Analyst, Fixed Income Strategies, US at Morningstar Research Services, and Jessica Shill, Portfolio Manager at Janus Henderson Investors.
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2025 Morningstar Investment Conference - Paul Olmsted, Jessica Shill, Bryan Whalen, and Edwin Wilches
What Are CLOs?
A CLO is fundamentally a portfolio of loans, primarily bank loans to US corporations, which are often high-yield, explains Edwin. The unique aspect of a CLO is how it takes this portfolio of loans and creates different levels of risk layering or tranches. These tranches range from the safest, AAA-rated securities at the top, down through various debt layers to equity at the bottom. Jessica adds that the AAA-rated CLO tranches are considered the safest securities in terms of credit risk. Investors can choose a tranche based on their specific risk and return preferences.
It is critical to decouple CLOs from the Asset-Backed Securities (ABS) CDOs that contributed to the financial crisis in 2008. Bryan stresses the importance of decoupling CLOs from the CDOs that caused significant financial pain, noting that while CLOs were outstanding during the crisis, they have not undergone the same problematic evolution as ABS CDOs. Jessica reiterates that CLOs were outstanding during the crisis, but it's important to differentiate them from the CDOs that were blowing up.
Why CLOs Are an Attractive Investment
CLOs offer several compelling advantages within fixed income portfolios:
- Floating Rate Nature: Jessica explains that CLOs are floating-rate instruments, meaning their interest payments adjust with benchmark rates. This can be beneficial in a rising interest rate environment or a "higher for longer" narrative from the Fed, as the term rate is expected to settle much higher than during periods like Covid or the taper tantrum.
- Structural Advantages:
- Seniority: Bryan points out that despite many underlying leveraged loans being low investment grade, they are senior secured, placing them higher in the capital structure. Jessica highlights that the AAA-rated CLO tranches are considered the safest securities in terms of credit risk. Bryan further states that historically, any CLO that is 95% or more backed by loans has never experienced a loss at the single A or higher level.
- Structural Cheapness: Bryan notes that CLO sectors tend to be structurally cheap. Jessica agrees, stating that CLOs screen as cheap compared to corporate credit. Jessica also clarifies that this structural cheapness isn't a reason to avoid investment but rather a reason to buy, though it's uncertain if they will remain structurally cheap forever.
- Market Dynamics:
- Shift to Private Markets: Bryan states that CLOs have significantly benefited from the global shift away from public markets towards private markets, not just private credit, but also a shift from bonds to leveraged loans as a source of corporate financing.
- Raw Material Growth: This move has fueled the CLO market because the underlying raw material, leveraged loans, has grown substantially, from a sub-trillion-dollar asset class to approximately $1.7 trillion. This expansion creates a large opportunity set for building new CLOs, according to Bryan.
- Market Dominance: Bryan and Edwin both state that CLOs currently own about 70% of the bank loan market. Bryan adds that this provides a wide array of investment opportunities and promotes liquidity because the more CLOs exist, the more market participants can trade among themselves.
- Low Duration: Bryan explains that unlike traditional bonds, CLOs do not have duration, meaning they did not experience the significant pain bonds did during periods like 2022 when interest rates rose. This made them an ideal investment when the yield curve was inverted, as cash was paying more than longer-term treasuries, and CLOs offered an additional spread, Bryan concludes.
The ETF Wrapper: Democratizing CLO Access
For individual and small institutional investors who often lack the resources or time to properly underwrite the complex CLO asset class, the ETF wrapper provides a vital solution. Bryan highlights that it effectively allows investors to outsource the underwriting and management to expert portfolio managers.
Jessica expresses a strong preference for the ETF wrapper, considering it one of the most liquid fixed income options. The ETF wrapper offers several distinct benefits:
- In-Kind Creation and Redemption: Jessica identifies this as a key advantage, noting that ETFs can create and redeem shares "in kind" (with shares or underlying bonds) in addition to cash. In stressed market conditions, like March 2020, this mechanism allows fund managers to deliver bonds in kind rather than being forced to sell them below their mark, thus mitigating cash drag and preventing additional losses for the fund and its long-term investors.
- Lower Fees: Jessica points out that fees for ETFs tend to be much lower compared to traditional mutual funds.
- Liquidity and Settlement: Jessica explains that unlike bank loan funds that require carrying a high amount of cash due to long settlement periods, which drags on performance, CLOs settle like normal bonds, enabling immediate trading of highly-rated tranches (e.g., AAA CLOs). Bryan corroborates that bank loan funds often need to carry 5-10% cash due to long settlement periods, making it hard for them to beat their index.
- Transparency: Jessica states that ETFs offer better transparency for investors. Edwin adds that for AAA CLOs, there is a high degree of confidence that an investor can sell at the price displayed on the screen on any given day.
Navigating Risks and Market Dynamics
Despite their advantages, investing in CLOs, particularly through ETFs, comes with considerations:
- Complexity and Barriers to Entry: Bryan describes CLOs as "living, breathing investments" that are constantly changing, not static. This complexity leads to high barriers to entry, as constant monitoring and re-underwriting are required. This demanding work is a reason for the attractive spreads in the CLO market, according to Bryan. He further explains that active managers often incorporate AI to navigate the nuances of deal documents, as every single deal can have unique aspects that impact the capital structure.
- Non-Standardized Documentation: Jessica highlights that one of the most challenging aspects for underwriters is the lack of standardization in CLO documentation. She notes that covenants are not standardized, meaning one deal can be run very differently from another, which necessitates deep due diligence.
- Liquidity Concerns: Bryan confirms that AAA CLOs proved to be one of the most liquid asset classes during market stress events like March 2020. Edwin adds that they were also highly liquid in September 2022. However, Bryan cautions that they are still a single asset class. In a macro environment that is unfavorable for leveraged loans or high-yield bonds, or where the yield curve is steeper, there could be an "exodus" from the asset class if CLOs don't offer competitive yields relative to other investments, Bryan warns. Edwin emphasizes that liquidity is a key consideration, especially when moving down the capital structure.
- Portfolio Allocation: Bryan suggests that CLOs should generally be considered a complement to money market investments or as a component of low-interest rate exposure, rather than replacing an entire portion of a portfolio.
- Evolving Market and New CLO Types: Bryan advises caution as new CLO types emerge, such as those backed by commercial real estate or infrastructure loans. He states that these will be harder to price and represent a fundamentally different underlying vehicle than traditional CLOs backed by diversified bank loans. Therefore, Bryan concludes that investors must be careful and conscious of what a CLO ETF is backed by.
The Importance of Active Management and Scale
Given the inherent complexity and non-standardized nature of CLOs, active management is essential, according to Jessica. She suggests that a passive portfolio strategy, simply aiming to hit benchmark metrics, may not achieve the best exposures in this market. Jessica explains that active managers spend significant time understanding different market nuances, including primary and secondary markets, and performing both quantitative and qualitative analysis.
Furthermore, scale and influence are critical for CLO managers, states Bryan. He highlights that being a large player (e.g., managing over $10 billion in investments) provides significant benefits:
- Access: Larger firms have better access to primary and secondary markets.
- Systems and Resources: They possess superior systems for pulling different metrics and aggregating data, which is vital for security selection and generating alpha, as described by Jessica and Bryan.
- Deeper Due Diligence: Bryan explains that large managers can leverage internal teams, such as bank loan teams, to conduct thorough credit analysis on the underlying loans, providing a better understanding of the managers they are evaluating.
- Market Influence: Bryan asserts that size and volume can provide an advantage in the market, ensuring that larger players can secure allocations in new deals.
Edwin points to the dispersion of spreads even within the same CLO index (e.g., 40 basis points between the tightest and widest spreads in the JPMorgan CLO index) as evidence of the value added by skilled active managers who can differentiate and select securities effectively.
