The Federal Reserve held rates steady at its latest meeting, which leaves investors doing something they hate: guessing. That guesswork is pushing money into a corner of the bond market that used to belong mostly to institutions.
They are buying exchange-traded funds that hold bundles of corporate loans, known as collateralized loan obligations, or CLOs. The demand is strong enough that some industry watchers think CLOs could be the next major growth area in the ETF business.
For years, CLOs were mostly the domain of institutional investors who could analyze complex capital structures and buy large stakes. ETFs change that by packaging slices of those loans into tickers that trade on an exchange, giving advisors and individual investors a simpler way to access the asset class. Reckoner Capital Management, an ETF issuer focused on CLOs, is bringing new CLO ETFs to market this year. That wave of launches is part of why strategists see the category gaining momentum.
A CLO is a bundle of corporate loans, sliced up and sold as a bond product. The loans are backed by collateral, meaning if a borrower goes broke, there is something to grab, and the safest slices get paid first.
The riskier slices get paid last, which is why they offer more income to make up for the extra danger. The loans inside the bundle pay floating rates, so the income rises and falls with the broader rate market.
That design helps CLOs hold up in different conditions and still hand out a decent yield, which is just the income a bond produces.
It is also why Todd Rosenbluth, research chief at VettaFi, sees CLOs as a possible breakout category for ETFs. "They've been popular within the marketplace," he said on CNBC's ETF Edge.
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They want income, but they do not want to lock up money for years and watch rates move against them.
"We've seen fixed income ETF demand be quite strong," he said. "I think that's going to continue as we're still waiting for some clarity from the next move of the Fed."
Rosenbluth also says the recent crop of CLO funds shows innovation in the bond ETF space. Advisors are taking notice too. TCW Group's distribution head, Jennifer Grancio, notes that many advisors build a core income portfolio and then add smaller CLO positions around it.
"I think a lot of advisors are holding a core income-oriented portfolio and then dabbling a little bit with short duration or CLO products," she said.
Not every slice of a CLO is equal.
There is another wrinkle. The loans inside these pools lean heavily on tech and software companies, so the whole pile depends on tech's health.
If tech stocks sell off or private credit worries spread, those loans feel the pressure, and investors demand more yield to hold the debt, which pushes prices down. A CLO is only as calm as the loans sitting in the pile.
Rosenbluth says investors are now hunting for AAA-rated and senior-secured assets.
That is exactly what CLO ETFs promise, at least for the upper slices.
The rise of these funds is a reminder that yield always comes with a risk scale. The top slice is close to boring in the best way.
The lower slices are where the extra income and the extra danger both live. With the Fed keeping everyone in suspense, that trade-off is not going anywhere.
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