CLO Debt ETFs Or CLO Equity CEFs: Which Are Best For Income Investors And Retirees

seekingalpha08-27

CLOs have several tranches.Equity tranches are the riskiest ones, but also have the highest yields, and strongest potential returns.Debt tranches are safer and lower-yielding, some significantly so, ...

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PM Images Several subscribers have asked for my thoughts on CLO equity CEFs, including the Oxford Lane Capital (OXLC) and the Eagle Point Credit Co. (ECC). Although the distribution yields and potential returns on these CEFs are incredibly high, I much prefer funds focusing on CLO debt, including the Janus Henderson B-BBB CLO ETF (JBBB) and the Panagram Bbb-B Clo ETF (CLOZ), as these have several important advantages over equity CLO CEFs. Specifically, these ETFs focus on more senior CLO tranches, have much lower credit risk and volatility, and stronger risk-adjusted returns. Dividend yields are lower, in the 7.7% - 9.0% range compared to 18.3% - 19.3% for the CEFs, but still quite high. Prices are better, with the CEFs trading at sizable premiums to NAV. As such, I would not be investing in CLO equity CEFs right now and would focus on ETFs instead. A significant reduction in rates or discounts might cause me to re-assess, but the situation right now seems clear enough. Credit Risk Analysis Some context first. CLOs are securitized investments using senior loans as their building block. Senior secured loans are variable rate loans from banks to medium-sized, riskier companies. Senior loans are generally bundled together in CLOs. Each CLO is divided into tranches. Income from the senior loans is used to make payments to all tranches. Senior tranches get paid first; junior tranches get paid last. Investors can buy into these tranches and receive income from the CLOs / portfolios of senior loans. Quick graph of how these are structured.   Stanford Chemist SA Article Different funds focus on different CLO tranches, with different implications for shareholders. A quick look at some of the larger funds in this space.   Fund Filings - Table by Author Simplifying things a bit, we can say that the Janus Henderson AAA CLO ETF (JAAA) is the first to receive coupon and capital payments from its CLO investments, then comes JBBB, then CLOZ, with OXLC and ECC last. This isn't quite right, the funds invest in several different CLO tranches, but close enough. JAAA is the most senior fund, so its dividends and capital are incredibly safe, and resilient during downturns and recessions. As an example, JAAA's NAV decreased by 2.3% in 2022, during which both bonds and equities saw double-digit drawdowns. Losses were limited due to JAAA's seniority, and its negligible duration.   Data by YCharts OXLC and ECC are the most junior funds, so their dividends and capital are both incredibly volatile, and both see significant drawdowns during downturns and recessions. OXLC and ECC were down 32% - 33% during 2022, significantly higher drawdowns than average.   Data by YCharts JBBB and CLOZ are somewhere between these two extremes. Credit risk is objectively quite low, with 10y cumulative default rates of 0.5% - 2.3%, annualized to 0.05% - 0.23%.   S&P Drawdowns tend to be a bit higher than expected, due to issues of liquidity and market perceptions of risk. JBBB's share price declined by 11.1% during 2022, for instance. Drawdowns were below-average, but higher than expected from fundamentals.   Data by YCharts CLO equity tranches have the highest credit risk, volatility, and drawdowns in the CLO space, a significant negative for shareholders. CLO debt tranches are much safer, an important advantage. Dividend Yield Analysis Riskier investments tend to carry higher yields, and CLO equity tranches are no exception. In exchange for their significant risk, OXLC and ECC sport strong double-digit distribution yields, in the 18.3% - 19.3% range.   Data by YCharts Although the (starting) yields are quite enticing, the long-term distribution track-record is disastrous, with both funds seeing significant distribution cuts since inception.   Data by YCharts By my calculations, OXLC's distributions have decreased by a 17.0% CAGR these past ten years, 12.0% for ECC's distributions. Long-term yield on costs are much lower than starting yields, with OXLC having a 10y yield on cost of only 6.5%:   Seeking Alpha ECC, a much stronger 11.1%:   Seeking Alpha OXLC and ECC's distribution cuts were due to declining NAVs and income, and due to their distribution policies. CEFs have some leeway in their distributions, so some of these cuts could have been averted by more significant earlier cuts. On the other hand, CLO equity tranches are structured in such a way that frequent, significant losses are almost certain to happen, so distributions should trend downwards long-term. CLO debt ETFs have much lower yields, in the 6.4% - 8.0% range.   Data by YCharts These ETFs are too young for me to meaningfully analyze their long-term dividend growth track-record, but it will almost certainly be much stronger than that of OXLC and ECC. CLO debt tranches are safer and suffer fewer drawdowns than equity tranches, so their distributions are much more long-term sustainable. For what it's worth, these ETFs have not seen their yield on costs materially decline since inception. CLOZ's is actually a bit higher.   Seeking Alpha - Table by Author CLO equity CEFs have higher distribution yields, but the dividend yields on the CLO debt ETFs seem high enough, and much more long-term sustainable to boot. In my opinion, the income offered by the ETFs is more than enough for most income investors and retirees, so picking the equity CEFs is somewhat unnecessary, and excessively risky. Stronger Risk-Adjusted Yields and Returns CLO debt ETFs combine strong, above-average yields with significantly below-average credit risk, duration, and volatility. Risk-adjusted yields and returns are strong, and much stronger than those of bonds and equities.   Data by YCharts CLO equity CEFs suffer from excessive volatility. This is due to some combination of underlying CLO volatility, and the fact that CEF discounts / premiums are constantly in flux. Sharpe and Sortino ratios are much lower, as expected.   Data by YCharts CLO debt ETFs offer investors much stronger risk-adjusted yields and returns, a significant benefit for shareholders, and an advantage relative to their equity peers. Similar Absolute Returns CLO equity tranches should outperform debt tranches, due to their excess risk and yield. This has mostly not been the case in the past, with JBBB outperforming on a NAV basis since inception:   Data by YCharts CLOZ matching their price performance. NAV seems higher, but there are data issues here,   Data by YCharts JAAA has underperformed, but at massively lower risk and volatility:   Data by YCharts In my opinion and experience, the relative performance of these securities has almost entirely been due to timing. Economic conditions and industry conditions have been incredibly volatile these past few years, especially in fixed-income markets, so returns are incredibly dependent on timing. Specifically, JAAA's comparative performance looks weak because it includes OXLC and ECCC recovering from the pandemic, but not their earlier losses. CLOZ looks a bit weaker because it excludes most of the Fed hiking cycle, and the losses experienced by OXLC and ECC. JBBB seems like the most neutral timing, starting just before the Fed started to hike, at least compared to CLO equity tranches. In any case, the average performance of CLO equity CEFs is another negative for shareholders. In my opinion, as the performance of these funds was strongly impacted by timing, I wouldn't put too much importance on this issue, but it is still of some importance. Risky investments do not always pan out, and that seems to have been (somewhat) the case for these CEFs in the past. Better Prices CLO debt ETFs rarely trade with significant discounts or premiums to NAV, with these generally been small and short-lived. Right now, these ETFs trade very close to NAV.   Data by YCharts CLO debt CEFs sometimes trade with significant discounts and premiums. Right now, both trade with significant premiums.   Data by YCharts These premiums are a significant negative for prospective investors, and a deal-breaker for me. Discounts and premiums do change all the time, so investors might get a better entry point / buying opportunity for these CEFs in the future. Right now, avoiding them seems best. Conclusion  CLO debt ETFs have much lower risk and volatility than CLO equity CEFs, with stronger risk-adjusted returns. Dividend yields are much lower, but still higher than average. Prices are better too, with the ETFs trading at NAV, the CEFs at significant premiums. Under these conditions, CLO debt ETFs seem like much stronger investment opportunities than CLO equity CEFs.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2462348291"}