ABS vs. CLOs: Why ABS Stand Out in Today’s Market

Uncertainty surrounding trade wars, tariffs and Fed policy has triggered broad market volatility. We believe these factors have also increased the likelihood of a slow-growth economy.

Over the next several months, we expect more Fed easing and wider credit spreads. We believe this environment should favor shorter-spread-duration ABS over longer-spread-duration CLOs.

By locking in ABS yields at current rates, we think institutional investors have the potential to maintain existing income payments with little price disruption.

Conversely, floating-rate CLOs will likely experience declining income and price depreciation, given our outlook outlined above.

Evaluating ABS vs. CLOs in Today’s Fixed-Income Market

We believe ABS, particularly those backed by non-traditional collateral, offer compelling opportunities for institutional investment portfolios.

Many firms have traditionally focused on high-quality corporate and government bonds to help meet their various investment objectives. However, by emphasizing these bonds, institutional portfolios may sacrifice additional goals that ABS and other securitized securities can potentially deliver.

ABS Characteristics: Yield, Duration and Diversification

In particular, ABS can help investors pursue key yield enhancement, duration and diversification goals. Institutional portfolios typically consider ABS for their potential to deliver higher yields and cash flows than many corporate bonds.

Additionally, the assets have featured lower interest-rate sensitivity than traditional fixed-income sectors. Furthermore, the ABS subsector is diverse, containing traditional securities backed by consumer loans, credit card debt and less familiar collateral.

For example, non-traditional ABS backed by aircraft leases, apartment rentals, data centers, timeshares, cellular towers and music royalties are typically underfollowed. We believe this variety can help overall portfolio diversification, performance potential and risk management.

How Economic Conditions Influence CLO Performance

We expect mounting evidence of an economic slowdown in the coming months, prompting the Fed to continue its rate-cut campaign. Under these conditions, CLOs have historically underperformed other fixed-income assets. Here’s why:

• CLOs are floating-rate securities; their income payments decline along with falling federal funds interest rates.

• Unlike other fixed-income securities, CLOs offer little price appreciation potential in declining rate environments.

• We believe that carry, the primary driver of CLO performance, will likely diminish over the next few years as interest rates decline.¹

• CLOs, which are largely comprised of bank loans and other leveraged loans, are sensitive to economic cycles. When the economy slows, the risk of default of the underlying debt increases.

Limited Sector Diversity in CLOs: Tech and Health Care Dominate

The information technology and health care industries dominate the CLO market, limiting the subsector’s diversity. Because of this, there is considerable overlap among CLOs, which can lead to highly correlated performance across the market.

Additionally, technology companies have boosted their use of leveraged loans in recent years. As the economy slows, any corresponding increase in technology-sector defaults could trigger losses in the CLO market, where many of these leveraged loans reside.

How Could Fed Rate Cuts Affect Securitized Securities?

While credit quality is an inherent risk for CLO investors, we don’t believe it’s the key risk in today’s market climate. Instead, we believe income and total return considerations remain paramount, given expectations for the economy to weaken and the Fed to cut interest rates.

In our view, CLOs would likely offer attractive performance potential if the Fed were to remain on hold or raise interest rates.

However, Fed officials have said they believe rates remain restrictive and will lower them to a neutral level when the time is right. While the timing remains unclear, the direction is not.

CLO yields are highly levered to the forward yield curve, which represents market expectations for the future path of interest rates. Observable market data, such as futures contracts, swap rates and current Treasury yields, help plot the forward yield curve.

Given their sensitivity to rate expectations, CLOs’ performance potential declines when the market anticipates interest rates dropping.

Figure 1 shows several hypothetical tranches of securitized securities, with different credit ratings, duration and yield profiles, and the effects of Fed easing. Assuming two quarter-point Fed rate cuts in the next six months, only the CLO yields declined, as indicated by the yield-to-forward metric. Yields on the sample CMOs and ABS remained unchanged.

Our analysis also assumed credit spreads widened by 50 bps due to market concerns about a slowing economy. Prices broadly declined, most notably among CLOs, as Figure 2 illustrates.

This hypothetical scenario reveals that Fed easing and credit spread widening had a combined greater effect on the total return potential of CLOs. The sample CMOs and ABS experienced no yield changes and smaller price declines.

ABS Outshine CLOs in a Changing Economic Landscape

Slowing economic growth and ongoing market volatility create a more challenging investment environment for institutional investors. We believe securitized securities offer important features that can help with diversification during periods of market uncertainty.

In our view, high-quality securitized bonds, particularly ABS, have the potential to provide more attractive and consistent yield potential than CLOs, corporate bonds and other fixed-income assets during easing rate environments. We also believe the shorter-duration profile of ABS highlights the risk-management potential these securities may deliver to investors.