CLOA: AAA-Rated CLO ETF, Good 6.1% Yield, Strong Performance (NASDAQ:CLOA)

I’ve been bullish on CLO ETFs these past few years, due to their strong, above-average yields and performance track-records. The BlackRock AAA CLO ETF (NASDAQ:CLOA) is one of BlackRock’s forays in this area, with the fund focusing on AAA-rated CLO tranches. CLOA’s above-average 6.1% yield, strong performance track-record, and extremely low credit and interest rate risk, make the fund a buy.

CLOA is extremely similar to the larger, more well-known Janus Henderson AAA CLO ETF (NYSEARCA: JAAA). CLOA has marginally higher returns, but JAAA has a marginally higher yield. Differences are tiny, with the funds being essentially interchangeable, in my opinion at least.

AAA CLOs – Overview

A quick look at CLOs as an asset class before tackling CLOA itself. Feel free to skip this section if you already know how CLOs work.

Senior secured loans are variable rate loans from banks to smaller, riskier companies. These loans are senior to other debt and secured by company assets.

Senior loans are sometimes bundled together in CLOs. Each CLO, or portfolio of senior loans, 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, including CLOA, can buy into these tranches to receive income.

In visual form. CLOA’s tranches highlighted.

So, CLOA invests in portfolios of senior loans, receives income for doing so, and its income is senior to that of most other investors.

With the above in mind, let’s have a closer look at the fund.

CLOA – Overview and Analysis

Extremely Low Credit Risk

CLOA focuses on AAA-rated CLO tranches, with smaller investments in those rated AA and A.

As mentioned previously, senior CLO tranches get paid before junior tranches. AAA-rated tranches are the senior-most tranche, so they get paid first amongst all tranches. The securities backing these CLOs effectively always generate sufficient income for the senior-most tranche, making these incredibly safe investments. Securities backing these CLOs do sometimes default, but it is investors in the lower tranches who must bear any losses, initially at least. In practice, investors in the lower tranches almost always bear effectively all losses.

In fact, not a single AAA-rated CLO has ever defaulted, and these investments have existed for several decades. Default rates for AA and A-rated tranches are incredibly low too, but not zero.

Due to the above, CLOA’s credit risk is extremely low, which should lead to below-average losses / outperformance during downturns and recessions. As the fund is quite young, with inception in early 2023, I can’t really analyze its performance during any such scenario. Still, I’m quite confident that this will prove to be the case.

Extremely Low Rate Risk

CLOA’s CLOs are variable rate investments, which means extremely low duration and rate risk. Specifically, the fund sports a duration of 0.10 years, much lower than most bonds and bond sub-asset classes.

CLOA’s duration should lead to much lower losses when rates rise than its peers, leading to outperformance. Rates have risen since the fund’s inception in early 2023, with the fund outperforming too, as expected.

CLOA’s variable rate loans should see steadily increasing coupon rates as interest rates rise, leading to dividend growth. This has not been the case since inception, but dividend volatility and an abnormally large dividend in March 2023 makes it difficult to know for certain.

JAAA’s dividends have increased though, and CLOA is extremely similar to that fund.

Notwithstanding the above, I’m quite confident that CLOA should see strong, swift dividend growth during any future hiking cycle. The fund’s underlying holdings are simply structured in a way that ensures this, and that was the case for its closest peer.

Corollary of the above is that fund dividends should decline as the Fed cuts rates. Which brings me to my next point.

Dividend Analysis

CLOA currently sports a 6.1% dividend yield, quite good on an absolute basis, and higher than that of most bonds and bond sub-asset classes. High-yield bonds do yield a bit more, but at significantly greater credit risk. Same is true for other relevant yield metrics.

Higher dividend yields are almost always a benefit for investors, and that includes CLOA.

CLOA’s dividends should decline as the Fed cuts rates. In my opinion, as the fund trades with a healthy spread to its peers, dividends should remain competitive for several years.

Specifically, the Fed would have to cut rates by 2.8% for CLOA’s dividend yield to match that of the Vanguard Total Bond Market Index Fund ETF (NASDAQ: BND), the largest bond ETF in the market and industry benchmark. The Fed is expected to cut rates 0.75% – 1.00% this year, and around 1.00% – 1.25% next year. CLOA would continue to yield more than BND these next two years, under these conditions. Although further significant cuts are possible, guidance is for rates to stabilize in the 2.5% range, allowing CLOA to yield (marginally) more than BDN for the foreseeable future.

Considering the above, I believe that CLOA’s dividends should remain competitive for the next few years. More dovish investors might disagree.

Insofar as dividends remain strong, the fund could continue to outperform even as rates go down. As an example, I would expect CLOA to outperform if the Fed only cuts rates by 0.25% this year, as the fund would continue to trade with much higher dividends than its peers. Such a small cut might put pressure on bond prices too, as the market is pricing-in more sizable cuts right now. Significant rate cuts would almost certainly lead to underperformance, however.

Performance Analysis

CLOA’s performance track-record is incredibly strong, with the fund outperforming most bonds and bond sub-asset classes since inception, and by very wide margins. Outperformance was mostly due to the fund’s low duration, but its above-average dividends played a role too.

CLOA is an incredibly stable fund too, as can be seen above, and when comparing the fund’s volatility with that of its peers.

On a more negative note, CLOA’s performance track-record is very short, as the fund was created in early 2023. JAAA is quite similar to CLOA but a bit older, with inception in late 2020, and has outperformed since inception too. High-quality CLO tranches have performed exceedingly well these past few years, even though CLOA has only been around for one.

I don’t expect CLOA to significantly outperform moving forward as interest rates have stabilized, but I do expect good returns at very low risk.

CLOA versus JAAA – Quick Comparison

CLOA offers investors strong, stable returns and an above-average yield, as does JAAA. Due to the significant similarities between these two funds, thought to do a quick comparison.

Both funds focus on AAA-rated CLO tranches, with smaller investments in AA and A-rated tranches. JAAA does have slightly higher credit quality than CLOA, the difference is small, however. Compare JAAA’s credit quality:

with that of CLOA:

Due to the above, the characteristics of both funds are similar. This includes credit and rate risk, dividend yields:

and performance track-records:

As can be seen above, JAAA has a marginally higher yield, while CLOA’s returns have been marginally higher since inception. These are tiny differences, however.

JAAA is marginally more expensive, with a 0.21% expense ratio compared to CLOA’s 0.20%.

JAAA is the larger, more liquid fund, with $7.2B in AUM compared to only $108M for CLOA. Both funds have adequate volume, and similar bid-ask spreads of 0.02%.

Overall, I slightly prefer JAAA’s higher yield and extra liquidity, but these are extremely minor differences, neither of which should have a significant impact on the fund moving forward. JAAA and CLOA are functionally interchangeable funds, in my opinion at least.

Conclusion

CLOA’s above-average 6.3% yield, strong performance track-record, and extremely low credit and interest rate risk, make the fund a buy.