These New Loan Funds Could Yield Results

Looking for good yields in a low-yield environment? I've got a novel idea for you: Two recently launched exchange-traded funds that invest in AAA-rated collateralized loan obligations. The first is the AAF First Priority CLO Bond fund , which was launched in early September and currently has less than $10 million in assets. The other is the Janus Henderson AAA CLO fund , which was launched in October and now has over $100 million in assets. Current market conditions have AAA collateralized loan obligations, or CLO, tranches yielding around the three-month benchmark London InterBank Offered Rate, plus 1.2% to 1.5%. The majority of AAA CLO tranches are floating rate ones. The fixed-rate tranches tend to yield between 1.55% and 1.85%, and that makes sense as the three-month London InterBank Offered Rate is currently at about 0.25%. Remember, the London InterBank benchmark interest rate is the one in which the world's big banks use to lend to each other for short-term loans. Both ETFs, according to Bloomberg, have expense ratios of 0.25%, so these products should provide income of around 1%. How Does the Yield Stack Up? Let's look at how the 1% yield compares to other income investments. Money market funds are yielding barely 0.1%. These funds are a completely different risk profile, but worth noting. If you wanted to buy a Treasury and earn 1% income, you would need to buy Treasuries that mature at least 10 years from now. Again, that's a different risk profile. So, let's look some other ETFs. First, the PIMCO Enhanced Short Maturity Active fund . This one has over $14 billion in assets and has an indicated yield of 0.62%, according to Bloomberg. MINT invests in corporate and agency debt, largely floating rate and with maturities that are less than five years and shorter than that by far on average. Next is Vanguard Short-Term Corporate Bond Index fund , with over $33 billion in assets. VCSH invests in up to five year corporate bonds and has a portfolio yield of 0.92%, according to Bloomberg. Then there's the iShares Floating Rate Bond fund and the SPDR Bbg. Barclays Investment Grade Floating Rate fund . Both invest in floating-rate corporate debt, and yield between 0.52% and 0.62%. Finally, we have the Invesco Senior Loan fund , which invests in leveraged loans directly, and has a yield of 3.3%. Avoiding 'Collateral' Damage: How Does the Risk Compare? Evaluating how risk compares in these funds is complex. Since the collateralized loan obligations themselves -- and the underlying loans they invest in -- are floating rate, there is little interest rate risk. Having said that, with the Fed effectively on hold in terms of interest rate hikes, all of these income products that invest in 5-year maturities or less, have minimal interest rate risk. Investment-grade corporate bonds are safer than leveraged loans. You can see that in the yields offered by VCSH vs. BKLN. That risk difference is obvious and you can see it in the pricing of the products: 0.92% vs. 3.3%. There is little margin for error in a corporate bond fund. Any default has a big impact on price and total return. But, defaults are rare, especially in short maturity funds. Leveraged loans will have higher default rates, but the fact that they are senior, tends to mitigate the impact relative to high yield bonds. These have similar issuers, but one is secured vs. the other, which is unsecured. Where Does AAA CLO Fit In? Credit risk is quite low. CLOs are one of the structured products that made it through the 2001 to 2002 credit turmoil and the Great Financial Crisis without experiencing credit losses. That is the good news. The bad news is that when the underlying loan market experiences volatility, it will impact the price of a AAA CLO tranche. My experience shows that you have more than enough of a buffer to avoid default losses. The rating agencies seem to have it right on this product, unlike the mortgage-backed products that led to the trouble of American International Group . The concern is whether you have enough of a buffer and market liquidity to avoid having to sell at prices that are arguably too low. The market for AAA CLO's has improved, because many of the holders are institutional investors who are not subject to mark to market and selling pressure. Final Decision I would look at CLO's. I think they offer potentially good risk vs. reward, but with some potential rating agency actions on companies, and CLO's themselves ahead of year-end, I would hold off investing in these. Also, I am not sure that the ETF structure makes sense for these products. It isn't bad, but may not be ideal. In sum, I'd also explore some actively managed income funds that include CLOs -- including some lower rated tranches that provide significantly more income.

These New Loan Funds Could Yield Results

Let's look at exchange-traded funds that invest in AAA-rated collateralized loan obligations and see how they stack up.

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