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Loans will always be CLOs’ main squeeze, but bonds are becoming an increasingly attractive side piece for portfolio managers.

High yield is now offering nearly 600bps over Treasuries. BofA analysts recently suggested this might be enough to compensate for recessionary credit losses, and advised: “prepare to go overweight.”

Many US CLO managers already have. According to the same BofA report, they now collectively hold an estimated $3.3bn of bonds, having added $2bn just this year.

Cheap bond prices are the main reason for this. CLOs have been allowed to hold bonds since a 2020 Volcker Rule amendment that eased rules on what they could invest in — many now have a bond bucket of around 5%.

In this market, that gives managers more flexibility to build par by buying bonds at bargain prices.

As 9fin readers will be all too aware, the leveraged loan market is undergoing its own price dislocation, so there are bargains to be had there too. But bonds have sold off considerably more, and can offer diversification to boot.

“Most CLO managers are using it to build par, but it also enables you to swap out loans that are trading in the low 80s that you’re uncomfortable with,” said one manager.

CLO managers’ wandering eyes don’t necessarily stop at high yield, either. Some are also dipping their toes into low-coupon investment grade bonds, which are trading off on duration risk as interest rates climb, several sources noted.

Microsoft and Apple are just two examples of investment-grade issuers with a growing fan base in the CLO market, said the BofA analysts, noting that managers have been picking up IG bonds at around 90 cents on the dollar.

As well as building par, dipping into bonds can also strengthen WARF tests, said Laila Kollmorgen, a CLO tranche portfolio manager at PineBridge Investments.

“You can still build par through the loan market, which is trading at attractive levels in the low 90s, but if you’re also able to look at high yield bonds in the 80s, that’s another 10 points in convexity and par build, and you’re arguably going up in terms of credit quality,” she said.

Indeed, the bond bucket seems tailor-made for today’s market dislocation. A leveraged loan portfolio manager went as far as to suggest that this feature was still “probably underutilized”.

“In a market like this, it can be incredibly helpful,” the PM said. “There’s a ton of good quality stuff trading at a discount, just because of where rates are. Its kind of a no-brainer.”

There are catches, however. For one thing, high yield bonds are significantly more volatile than loans; sources noted that CLOs should be highly selective when using this strategy, especially given the increasing threat of credit downgrades, which can put portfolio tests in jeopardy.

The Fed is hiking much faster than expected, putting fixed-rate bonds at a considerable disadvantage to floating-rate loans — and this is all part and parcel of an increasingly bearish economy, where free cash flow and interest coverage are being squeezed.

Source: BofA Global Research, Bloomberg, Intex

Some CLO indentures also allow managers to hold unsecured bonds, which offer extra returns but entail higher risks. This is a divergence from one of the main selling points for CLO investors, which is exposure to secured debt.

“The bond market is priced that way for a reason, so it needs to be a calculated risk add,” a fourth portfolio manager said. “It can be a creative way to take advantage of par build, but you do give up some economics.”

Lastly, the fast-pace of bond trading is a different ball game from loans, said another source, cautioning that CLO managers risk “getting their butts kicked” if they overextend their foray into the bond market.

CLOs’ recent infatuation with bonds is unlikely to move the needle on pricing, or lead to larger basket sizes in new deals (at least in the near term, given muted demand for CLO new issuance) but utilization of these buckets it is a trend that experts expect to steadily increase.

For now, many managers are using their bond buckets to buy defensive credits or move further down the capital stack in credits they like. But it’s unclear how long they’ve have to wait for prices to rise from today’s discounted levels.

“Sooner or later, there’s going to be a rebound in high yield and credit in general, and it will likely be aggressive” said one of the portfolio managers. “We’re just not sure exactly when it will come.”

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