CLO ETFs package up hundreds of corporate loans into tranches of risk to create different income streams, often providing a higher yield than traditional fixed income.SusanneB/iStockPhoto / Getty Images
The Canadian investment landscape has seen a handful of exchange-traded funds launch in recent weeks that offer exposure to private market, AAA-rated loans with yields exceeding investment-grade bonds and historically low default rates.
Yet, these ETFs − including those from three of the big banks − face a stigma because the underlying holdings, collateralized loan obligations (CLOs), are complex and carry negative associations.
“You can be sure providers have a bit of a hair-trigger defence mechanism because they want to differentiate these [ETFs] from the worst excesses of the great financial crisis,” says Daniel Straus, managing director of ETFs and financial products research at National Bank of Canada Financial Markets in Toronto.
CLOs weren’t a factor in the 2008-09 market meltdown, but investors may confuse them with derivatives with a similar name that did play a pivotal role. Collateralized debt obligations (CDOs) also bore AAA ratings but contained subprime mortgages that led to the near collapse of the global financial system.
CLOs have never held mortgages – prime or subprime. And yet, these new ETFs face an uphill climb among Canadian investors, in particular, despite their benefits, says Keith Pangretitsch, a veteran private wealth manager and president of Relevance Wealth Management in Toronto.
Mr. Pangretitsch is a consultant for Corton Capital Inc., a boutique asset manager specializing in exempt markets, which launched the first Canadian-listed CLO ETF last September.
CLOs package up hundreds of corporate loans into tranches of risk, with the most creditworthy making up the largest share to create different income streams, often providing a higher yield than traditional fixed income.
For example, Corton Enhanced Income Fund RAAA-T, which pays monthly distributions, invests in more than a dozen CLOs, each containing as many as 200 loans; the ETF provides a gross annual yield of 4.23 per cent (as of May 31).
Submanaged by alternative credit manager Astra Asset Management UK Ltd., the ETF invests across the more than $1-trillion global CLO market.
Yet, the ETF’s holdings today are focused on Europe’s more than US$280-billion CLO market, which offers wider spreads, making it more attractive, Mr. Pangretitsch says.
Despite CLOs’ ubiquity elsewhere, they remain unfamiliar to Canadian investors because no domestic market exists for these securitized debt instruments that pool asset-backed corporate loans, says Konstantin Boehmer, head of fixed income at Mackenzie Investments.
“There is no similar loan market in Canada,” he says, noting a deep, corporate floating debt market is required for CLOs.
Although a US$12-trillion market globally, driven by the U.S.’s massive private equity market, corporate loans are largely provided by Canada’s largest financial institutions and are not securitized, Mr. Pangretitsch says.
“Because those sit on the bank balance sheets, essentially hidden, retail investors assume they have to be risky due to unfamiliarity,” he says.
Yet, the products may become familiar soon, with CLO launches in May, including RBC AAA CLO (CAD Hedged) ETF RCLO-NE, BMO AAA CLO (CAD) ETF ZAAA-NE and CIBC Income Advantage Fund ETF CCLO-T.
Recent ETF data from National Bank shows the Canadian market now has nine CLO ETFs, including Mackenzie AAA CLO ETF MAAA-T and Brompton Wellington Square AAA CLO ETF CDN-hedged BAAA-T, launched in April.
The National Bank report states that inflows to these CLO ETFs were the largest among fixed-income ETFs in May.
As investors become familiar, demand is likely to grow. Yet, even providers recognize the stigma because of the products’ complexity and association with CDOs.
“Structured products, in general, have a bit of a bad reputation,” Mr. Boehmer says.
But he says CLOs shouldn’t be painted with the same brush: “There have been something like 5,500 tranches of AAA CLOs [globally] over the past 25 to 30 years … and there has not been a single default.”
Even among non-AAA CLOs, annual default rates are near zero over the past 20-plus years, lower than investment-grade corporate debt, according to a 2024 S&P Global report.
Their lower risk has long attracted institutional investors. Now, ETFs are “democratizing access to the CLO asset class,” Mr. Boehmer adds.
Still, some experts worry that the growing appetite for CLOs could reduce lending standards, making the underlying holdings more risky.
U.S. track record
The first CLO ETF – Janus Henderson AAA CLO ETF JAAA-A – launched in the U.S. in 2020 and has been “very successful,” Mr. Straus says. It’s the world’s largest CLO ETF with US$20-billion in assets under management.
“We see low volatility, extremely smooth, floating-rate-style performance that definitely displays – at least on the surface – much better risk metrics than traditional floating-rate bonds,” he says.
The strong track record aside, “you can never really rule out black swan risk,” Mr. Straus adds.
A recent TD Securities report highlights this downside potential, pointing to short-lived liquidity mismatches during market stress in early April amid peak tariff worries.
Janus Henderson AAA CLO ETF was “on a roller coaster ride on premiums/discounts to [net asset value]” that “triggered concerns among some investors,” the report says.
What’s more, the rapid growth of ETFs has led to worries that mass redemptions during market upheaval could put additional downward pressure on the CLO market. That said, the report adds that’s not a concern today, given that ETFs make up less than 3 per cent of the CLO market.
Still, investors must grasp that just because the ETFs hold AAA-rated assets, it doesn’t mean they’re risk-free, Mr. Boehmer says.
“These are not the same as a U.S. Treasury, but then, you’re also getting 140 basis points of additional compensation” over short-term Treasuries for the additional risk, he says.
What’s more, CLOs offer floating interest rates that help advisors manage inflation risk for income-needy clients, which would prove beneficial if inflation is more persistent than anticipated, Mr. Pangretitsch says.
“If your bond portfolio is meant to preserve purchasing power, then CLO ETFs will do that better than high-interest savings ETFs, for example,” he says.
Even amid falling rates, these investments still offer a significant spread over short-term securities, he adds.
For this reason alone, the arrival of Canadian-listed CLOs is healthy for the market, given floating-rate choices are limited and exposure is often underrepresented in Canadians’ portfolios, Mr. Pangretitsch says.
“It’s why we believe CLO ETFs should be a staple in more clients’ fixed income holdings.”