Senior loans and CLOs: High income potential and low duration exposure

Senior loan exposure, either directly or through collateralized loan obligations (CLOs), can make sense for investors looking for risk-adjusted income with low duration. Invesco has two exchange-traded funds (ETFs) that invest in the broader asset classes. While they both seek to provide high income, their underlying composition and risk profiles are different. Invesco Senior Loan ETF (BKLN) invests in the largest senior loans, while Invesco AAA CLO Floating Rate Note ETF (ICLO) invests primarily in the highest rated CLO tranche, AAA. So, how to choose between the two?

Senior loan and CLO need-to-knows

Senior loans, also known as leveraged loans or bank loans, are debt securities utilized by companies to finance their operations, support business expansion, and refinance existing debt. They’re senior because of their uppermost position in a company's capital structure, meaning they’re the highest priority to be repaid in a default. Senior loans are typically secured by the borrower's assets, such as cash, receivables, inventory, or property, and are structured as floating-rate instruments, which means the interest paid on these loans fluctuates with interest rate changes.

CLOs are backed by a pool of senior loans and have various coverage, collateral, and quality tests that manage them. They buy the underlying senior loans by issuing different debt/equity slices with different cashflow priorities. The most senior of these slices are AAA-rated and first in line for cash flow coming into the CLO.

BKLN versus ICLO: Key features

While both ETFs offer income and floating rate exposure, in general, consider BKLN for investors seeking higher yield who are comfortable with greater credit risk. ICLO makes sense for investors focused more on capital preservation, relatively lower volatility, and high credit quality. It can offer greater stability and lower credit risk and has historically still delivered high relative yields.

Why consider BKLN and ICLO?

A combination of characteristics may position senior loans and AAA CLO investments as a core holding in any environment.

• High current income potential: Base interest rates, while declining, are expected to stay relatively higher for longer, and credit spreads, which continue to remain close to longer-term averages, contribute to current income. The coupon income for bank loans and CLO AAAs today is 7.85% and 5.66% respectively, well above the long-term average.¹ Even if the Federal Reserve (Fed) cuts interest rates in the near term, market expectations are for cuts to be relatively shallow and for coupon rates to still be higher for longer, and remain well above pre-2022 levels.²
  
• Limited impact from rate volatility: Senior loans and CLO investments carry minimal duration risk, with an average duration of less than 90 days. While the market consensus is for rates to decline, the timing and amount of rate cuts remain unclear. Senior loans and CLO investments can be attractive in this environment. Their average pricing isn’t impacted by changes in the market perception of the timing or amount of rate cuts, compared to longer duration asset classes that could see performance increases or drawdowns based on it, which ultimately increase volatility.
  
• Compelling relative value: Currently, senior loan and CLO AAA spreads are tightening, but they’re still wide of similarly rated asset classes.³ That’s why we believe now is an attractive entry point for loans.
• Resilience during downturns: Both ETFs offer downside mitigation. The floating rate characteristic of senior loans and CLO AAAs, coupled with their secured nature and priority in the capital structure, have made them resilient during market downturns. Plus, CLO AAAs, sitting at the top of the seniority level, have never experienced principal impairment.⁴ 
  

Making a choice

Since both BKLN and ICLO provide senior loan exposure, directly or through a CLO structure, which to choose will largely depend on the investor’s risk tolerance and income needs.