CLOs Gain Amid Surge in Yields

The VanEck CLO ETF (the “Fund”) remains conservatively positioned relative to its benchmark, the J.P. Morgan CLO Index, as we expect downgrades to increase into 2024 as the impact of higher interest rates materializes. The Fund had approximately 90% exposure to AAA rated CLOs in September, versus under 70% in the benchmark. However, riskier tranches outperformed in the quarter, resulting in underperformance versus benchmark. Security selection is key in this environment, and the asset class’s high all-in yields and near zero interest rate sensitivity have driven outperformance versus other fixed income asset classes as rates have increased sharply across the curve. Against this backdrop with risks tilted to the downside amid tight valuations, we continue to position the Fund conservatively with the ability to shift into lower rated tranches when spreads widen.

Market Update

CLOs generated positive total returns across the capital stack in September, the sixth straight month of positive returns, with returns primarily driven by positive carry. The technical backdrop remained supportive as the strong levels of new issuance and a return of refinance and reset transactions. US Treasury rates traded sharply higher during the month with 5- and 10-year Treasury rates increasing 35 basis points (bps) and 46 bps, respectively. The move higher in longer-term Treasury yields extended into the third month, bringing the cumulative increase to 100 bps for both the 10- and 30-year US Treasuries relative to recent mid-July lows, with 10-year US Treasuries ending the month at the highest level since 2007. The move was less pronounced on the front-end of the yield curve with rates increasing 40 bps during this period for the 2-year yield.

The Consumer Price Index (CPI) recorded a 3.7% year-over-year increase in September and August compared to a 3.2% pace in July. The Federal Reserve kept interest rates unchanged at its meeting in September with dot-plot projections pointing to interest rates that are expected to stay above 5% through the end of next year. The move to a hawkish stance, relative to June, kept pressures on interest rates to move higher.

CLOs underperformed bank loans, but outperformed investment grade credit and high yield bonds during the month as fixed-rate debt continues to face headwinds from the rise in Treasury yields.

Source: JP Morgan and ICE Data Indices as of 9/30/202232. CLOs represented by J.P. Morgan Collateralized Loan Obligation Index, AAA Rated CLOs represented by J.P. Morgan CLO AAA Index, AA Rated CLOs represented by J.P. Morgan CLO AA Index, A Rated CLOs represented by J.P. Morgan CLO A Index, BBB Rated CLOs represented by J.P. Morgan CLO BBB Index, BB Rated CLOs represented by J.P. Morgan CLO BB Index, Investment Grade Corporates represented by ICE BofA US Corporate Index, US Agg is represented by the ICE BofA US Broad Market, Leveraged Loans represented by JP Morgan Leveraged Loan Index and High Yield Bonds represented by ICE BofA US High Yield Index.

CLO new issue supply decreased month-over-month, but remained robust overall, with $9.6bn pricing during the month, following $11.5bn in August. Year-to-date new issuance of $83.9bn is now trailing year-to-date activity in 2022 by 21%. Refi and reset activity continued in September with $3.1bn pricing, after $4.0bn in August. Compared to the first three quarters of 2022, year-to-date refi and reset volumes are 43% lower and 63% lower, respectively.

In the secondary market, TRACE supply was higher at $20.2bn from $19.7bn in August, the highest volume of the year. Investment grade volumes increased to $15.9bn from $15.7bn and below investment grade volumes increased to $4.3bn from $4.0bn. Total BWIC volumes increased to the highest level of the year at $5.7bn in September, up from $5.6bn in August.

The trailing twelve-month default rate within the Morningstar US Leveraged Loan Index fell to 1.27% in September, down from 1.55% in August, in the absence of new defaults. We anticipate the default rate to remain below historical averages in the near-term for the leveraged loan market, notwithstanding ongoing interest rate increases and indications that the Fed will maintain higher interest rates throughout 2023. However, our expectations are that defaults will increase in 2024 to 3%-4%, above the long-term historical average of roughly 3%.

CLO fundamentals were mixed month-over-month. CCC buckets ticked higher month-over-month while the exposure to loans pricing below $90 and $80 decreased alongside the rally in the loan market. US CLO spreads were tighter at the AAA level, while the rest of the cap stack was flat to slightly wider over the month.

Portfolio Strategy

As central banks increased interest rates in 2022 and thus far in 2023, the borrowing rate for leveraged loan borrowers has risen. Higher interest rates have yet to drive a material deterioration in credit metrics within the loan market or undercut economic growth. However, with expectations for rates to remain higher for longer, increased coupon payments for borrowers means that interest coverage ratios will decline as the lagged effect of rate increases takes hold. Ultimately, the result will be higher leverage and lower interest coverage ratios, leading to the risk of downgrade.

Thus far in 2023, we have looked to benefit from continued increases in interest rates, allowing for increased coupon income. Given expectations for the pace of downgrades to pick up to end 2023 and into 2024, we continue to position the Fund conservatively with the ability to shift into lower rated tranches when spreads widen. The positioning in the top part of the capital stack in CLOs (AAA/AA/A) buffers investors from lower tranche downgrades or losses at the equity tranche level.

Buying in the primary market allows for wider spreads compared to the secondary market, although primary issuance continues to trail the pace from the last two years and is expected to remain muted given challenges to CLO creation, although the arbitrage has improved with lower liability costs. While spreads tightened materially since May, we continue to find attractive opportunities in both the primary and secondary markets, where purchases in the secondary market below par provide for attractive positive convexity.

CLOI Total Return and Credit Allocation

Source: FactSet, JPMorgan, VanEck, As of September 30, 2023. Index performance is not representative of Fund performance. It is not possible to invest directly in an index.

Outlook Ahead

While the end of the tightening cycle is welcome news for many, tighter conditions for longer could create additional stress in the market, particularly for weaker borrowers. In addition, some cracks are showing in the economic backdrop. Job openings have decreased, indicating companies are pulling back from hiring new workers, consumer confidence has fallen amid nascent employment concerns, and credit card losses are rising at the fastest pace in nearly 30 years as the benefit of increased savings from Covid-era policies fades. Investors also must consider the impact of auto strikes, the end of student loan forbearance, and a potential government shutdown in November at expiration of the recently enacted 45-day spending bill.

Despite these downside risks, the macro outlook continues to be resilient enough to support our modestly increasing, but not spiking, default outlook, as the most extreme downside scenarios no longer seem as likely. Issuer default rates have ticked higher off historic lows but still remain below longer-term averages. Also of note, defaulting issuers continue to come from all but the most cyclical sectors which leads us to believe that macro conditions are not yet necessarily driving defaults. We are still cautious about the path of earnings in the face of restrictive monetary policy, while acknowledging the current level of fundamental strength.

Against this backdrop, the CLO market continued to rally since the lows in May. New issuance picked up significantly in recent months as managers looked to take advantage of tightening liability spreads. Despite the higher-than-expected supply, AAA and AA secondary spreads ended the month back down near Q1 levels while A-BB spreads are at or near the tights of the year as CLOs continue to see strong demand given high all-in yields. There was also a continuation in refinancing and reset activity as portfolios constructed with purchases in the secondary market took advantage of the recovery in the loan market and tighter CLO spreads. Should the loan and CLO markets continue to rally, we would expect to see more portfolios benefit from the significant redemption optionality in CLOs.

We expect earnings dispersion for underlying issuers heading into 2024 which means manager selection remains key. We anticipate CLO spreads to trade in a range for the next 3-6 months and see spreads and yields attractive under most market scenarios over the next twelve months. We also expect the CLO market to continue to be supported by the technical backdrop. Given tighter valuations and risks tilted to the downside, we continue to position the Fund in investment grade tranches. We expect that the backdrop will begin to improve within the next six months, at which point we would begin to add BBB and below investment grade rated classes to the Fund.

^* Returns less than one year are not annualized.

The performance data quoted represents past performance. Past performance is not a guarantee of future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Performance may be lower or higher than performance data quoted. Please call 800.826.2333 or visit vaneck.com for performance current to the most recent month ended.

The gross expense ratio for CLOI is 0.4%. CLOI Fees & Expenses: Van Eck Associates Corporation (the “Adviser”) will pay all expenses of the Fund, except for the fee payment under the investment management agreement, acquired fund fees and expenses, interest expense, offering costs, trading expenses, taxes and extraordinary expenses. Notwithstanding the foregoing, the Adviser has agreed to pay the offering costs until at least May 1, 2024.

The net expense ratio for CLOI is 0.4%.

The “Net Asset Value” (NAV) of a Fund is determined at the close of each business day, and represents the dollar value of one share of the fund; it is calculated by taking the total assets of the fund, subtracting total liabilities, and dividing by the total number of shares outstanding. The NAV is not necessarily the same as the ETF ‘s intraday trading value. Investors should not expect to buy or sell shares at NAV.

Originally published by VanEck on October 23, 2023. 

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