To squeeze more yield out of their income investments, investors have historically had 2 main options to choose from: Either invest in longer-dated securities (for example, buying 10-year Treasurys instead of 3-month T-bills), or invest in lower-rated securities (i.e., buying high-yield debt instead of investment-grade bonds).
Both of those options come with obvious tradeoffs. Investing in longer maturities exposes investors to more price volatility from changing interest rates, while lower-rated securities expose investors to greater risk of default.
Yet a new class of ETFs is turning those old tradeoffs on their head. By opening access to an asset class that was once off limits to everyday investors, these ETFs offer a way to potentially boost yield without the usual drawbacks. They still carry their own risks. But they also provide daily liquidity, minimal interest-rate risk, and even the potential to invest in AAA-rated securities.
Read on for what investors need to know about new collateralized loan obligation (CLO) ETFs, and why their unique mix of features might make them appealing for some yield-focused investors.
What are CLOs?
CLOs are structures that pool together a large number of underlying corporate loans. CLOs then issue securities backed by those loans, but with varying levels of seniority. For example, AAA-rated CLO securities have first claim on the cash flows paid by the pool of loans. Lower-rated securities issued by the CLO only receive payment after the higher-rated securities are paid up.
CLOs have long been favored by institutions like banks, insurers, pensions, and endowments, for the potential access to higher yields and the ability to fine-tune credit-rating exposure. But until the launch of CLO ETFs in recent years, ordinary investors had no way of building a dedicated exposure to the asset class.
What types of loans do CLOs hold?
CLOs hold bank loans, which can also be called floating-rate loans or leveraged loans. These are loans issued with rates that “float,” or adjust periodically—typically at some kind of set premium over a short-term market rate.
That floating feature is key to why the loans, and the CLO securities backed by the loans, do not carry significant interest-rate risk. When market interest rates rise, the interest rates on these loans rise as well, allowing their market prices to remain relatively stable. That’s in contrast to traditional fixed-rate bonds, which fall in price when market interest rates rise (fixed-rate bonds must fall in price when rates rise, so that they can be competitive with new bonds being issued at higher rates). Keep in mind that floating-rate loans generally are subject to restrictions on resale. They sometimes trade infrequently in the secondary market, so may be more difficult to value, buy, or sell. A floating-rate loan might not be fully collateralized, which may cause it to decline significantly in value.
The loans are generally issued by below-investment-grade companies and are often a favored form of financing used by private equity firms in conducting leveraged buyouts. But they’re not concentrated in any one sector or pocket of the economy—which helps provide diversification.
“The underlying issuers can be very diverse, across nearly all industries,” says David DeBiase, lead manager of Fidelity® AAA CLO ETF (
That diversification matters. “Individual loan performance is still important, but the default of a single name in the loan pool generally will not have a detrimental impact on a CLO’s rated debt securities,” says Michelle Liu, lead manager of Fidelity® CLO ETF (
How do CLO ETFs work?
CLO ETFs work like other ETFs—investing in a basket of securities, trading on an exchange like a stock, and offering the ability to buy or sell on any day that the market’s open—but invest primarily in CLOs.
The risk and return potential of more senior CLO securities can be very different from the more junior securities (the most senior securities are typically AAA-rated debt, while the most junior securities typically carry no credit rating and are considered equity). For that reason, most CLO ETFs target a specific part of the CLO capital structure.
For example, Fidelity® AAA CLO ETF (
Fidelity® CLO ETF (
Features of CLO ETFs
Here are some of the characteristics and features investors might encounter with CLO ETFs:
Potentially higher yields
“CLOs have historically featured higher yields relative to other products with the same credit rating,” says Liu. That’s likely because it is a relatively illiquid and complex market—appealing only to large investors who can commit large sums, and who have the resources to do the required research.
Limited interest-rate risk
Because the underlying loans pay floating rates, CLO securities typically have low duration and don’t see large price swings purely from changes in market interest rates. That can be an advantage in rising-rate environments (when traditional fixed-rate bonds often decline), and a relative disadvantage in falling-rate environments (when fixed-rate bonds often rise).
Active management
CLOs themselves are actively managed, allowing managers to adapt to changing economic and market conditions. Many CLO ETFs—including the new Fidelity offerings—are also actively managed, aiming to select managers, deals, and securities that balance income, liquidity, and downside protection. Active management can allow managers to avoid overvalued parts of the market, to get ahead of potential negative price moves, and adapt when market conditions change.
Embedded credit protections
Beyond diversification, the CLO structure often includes credit protections that can limit risk and help protect investors should credit stress rise. “There are many guardrails and covenants,” says Liu. For example, CLOs are typically overcollateralized—meaning they hold a portfolio of loans worth more than 100% of the CLO principal value. If certain thresholds of rising credit risk were triggered, all of a CLO's cash flows may be redirected to fully pay off the rated debt securities, beginning with the AAAs. While past performance is no guarantee of future results, DeBiase notes that AAA-rated CLO securities have never experienced a default.
Credit risk and price volatility
Even with these protections, CLOs are still exposed to credit cycles. Prices can move when investors reassess default risk or demand higher spreads. “If markets enter a risk-off period, investors could see temporary price declines,” says DeBiase. The magnitude of those moves may depend on tranche selection (AAA vs. mezzanine), manager quality, and market liquidity.
Daily liquidity
Like other ETFs, CLO ETFs trade on exchanges and can generally be bought or sold on any market day. (Learn more about the potential benefits of ETFs.)
Tax consequences
Distributions and capital gains from CLO ETFs are generally taxable (though the ETF structure can help reduce some types of taxable events). There may be a benefit to holding CLO ETFs in a tax-deferred or other tax-advantaged account, such as a traditional or Roth IRA. Consult with a tax professional to better understand how investing in CLOs may impact your personal tax situation.
How have CLOs performed historically?
New CLO ETFs do not have track records for investors to analyze. While past performance is no guarantee of future results, CLO indexes can give investors some sense of how the asset class has generally performed in different environments. As the chart below shows, CLOs have historically had higher returns potential in environments when interest rates are generally high.
What was the role of CLOs in the Global Financial Crisis?
Structured products famously played a leading role in fueling the 2008 to 2009 financial crisis, and many saw significant losses. In the alphabet soup of acronyms, it’s easy to associate CLOs with products such as asset-backed securities (ABS), collateralized debt obligations (CDOs), and residential mortgage-backed securities (RMBS).
But the true story is more nuanced. The greatest damage and losses flowed from securities backed by subprime mortgages—particularly mortgage-linked CDOs. Those products bundled risky home loans, which often rested on poor underwriting, into securitized structures. In many cases the resulting securities also received inflated credit ratings, due to inaccurate assumptions about rising home prices.
Because they own corporate loans and not mortgages, plus due to their active management and unique structures, CLO performance was actually resilient during the financial crisis and did not play a major role in fueling the crisis. Over the long term, impairments on CLO debt securities have generally been quite low.1 In fact, a Fed working paper found that, “CLO debt tranches default at a much lower rate than equivalently rated corporate debt.”2
All asset classes can face environments when they thrive and environments when they struggle, and CLOs could face bumpy patches in the future. But investors shouldn’t write them off simply due to the poor track record of a different (but similarly named) group of securities.
More on the ETFs mentioned above
Investors can learn more about the ETFs mentioned in this article, including ETF objectives and most recent complete holdings, by visiting the ETF summary pages on Fidelity.com:
- Fidelity® AAA CLO ETF (
) - Fidelity® CLO ETF (
)