Get to Know CLOs With William Sokol

Given their higher relative yields, “built-in” risk protection and historical outperformance in periods of rising rates, collateralized loan obligations (CLOs) are becoming an increasingly important component of broader fixed income portfolios. Like we have done in other asset classes, VanEck, in partnership with PineBridge, is proud to have brought the power of CLOs to more investors with the creation of the VanEck CLO ETF (CLOI). In this Q&A, William Sokol will answer top-of-mind questions from investors on our CLOI ETF.

• What sparked the idea of creating a CLO ETF?
• Who stands to benefit from CLOI?
• What is CLOI’s investment focus within the CLO spectrum?
• How has CLOI performed in the current market environment?
• How will CLOs perform if the Fed lowers rates in 2024?
• What are the benefits of an actively managed CLO fund?
• How do you address liquidity concerns in stressful market conditions?
• Has CLOI experienced any defaults?
• Why do you think there is such a significant interest in CLOs currently?

What sparked the idea of creating a CLO ETF?

We began exploring the CLO ETF concept following a regulatory shift in the U.S., which made it feasible to consider strategies with greater exposure to securitized asset classes like CLOs. More importantly, this regulatory change coincided with the significant growth of the CLO market, which had expanded to a global size of over $1 trillion. Additionally, the changing rate environment and the attractive yields offered by CLOs, especially when compared to traditional corporate bonds, further fueled the interest in this strategy.

Who stands to benefit from CLOI?

We believe all types of investors stand to benefit from accessing CLOs through an ETF. Until recently, it has been difficult for most investors to add exposure to CLOs. The market is largely institutional, and investors such as banks, insurance companies and hedge funds often purchase CLOs directly or invest through institutional separate accounts, which can carry a minimum investment of $50M to $100M. Actively managed multi-sector or core bond funds may include an allocation to CLOs, but investors cannot control the level of exposure and it may vary significantly over time.

Our CLOI ETF presents a compelling option for institutional investors who are currently already investing in investment grade CLO tranches, providing a way to access this asset class with greater liquidity and transparency. We also believe CLOI is attractive to a whole new set of non-institutional investors who have never been able to access CLOs. CLOI allows retail investors and their financial advisors to incorporate the benefits of investment grade CLOs that institutional investors have long enjoyed: attractive yields relative to similarly rated bonds and loans, and a high degree of safety thanks to their built-in risk protections.

What is CLOI’s investment focus within the CLO spectrum?

The ETF invests primarily in investment-grade CLO tranches, ensuring high-quality exposure. However, it maintains the flexibility to invest a small portion of the portfolio in BB-rated tranches if there is value in lower rated tranches.

We partnered with PineBridge on CLOI as they bring decades of experience in the CLO market and have been managing a strategy similar to CLOI for their institutional clients for many years. They take an active approach, and in addition to rigorous bottom-up security selection they also aim to add value from a top-down perspective by adding exposure to lower rated tranches when appropriate, and scaling back risk as needed by concentrating more in AAAs and AAs based on market conditions and their outlook. Currently, the portfolio is conservatively aligned, with the majority invested in AAA-rated CLOs.

How has CLOI performed in the current market environment?

CLOI’s year-to-date return is 8.64%¹, outperforming many other fixed income classes in 2023. Looking ahead, we believe high carry and fairly robust credit conditions can continue to support this strong performance. If the Fed maintains rates or even if they cut a few times in 2024, we believe the carry that investors are earning will remain very attractive. Even if CLO spreads were to widen to levels that we saw in March 2020 with COVID, CLO investors could still have a positive year in 2023 because of the high level of carry. But this is a dynamic strategy that can adapt to changing credit fundamentals and interest rate scenarios.

How will CLOs perform if the Fed lowers rates in 2024?

Investors should understand that CLOs are not just a hedge against rising rates. They also have historically provided higher levels of income for a lower level of risk – making a clear case for a strategic allocation, regardless of Fed policy. They’ve consistently provided a significant spread pickup against similarly rated corporates. The majority of the current yield pickup right now is coming from that spread pickup rather than the high level of short-term rates. And CLOs have very low correlation to the broad U.S. investment grade market, so there are significant diversification benefits from a strategic allocation.

If the Fed ends up cutting more aggressively in 2024 than the market is expecting, we would expect that to coincide with a risk-off environment. That could push value into lower rated CLO tranches, and allow investors to capture high absolute yields as well as attractive upside opportunities. But in order to take advantage of that scenario, you need an active approach that can invest across the CLO cap stack.

What are the benefits of an actively managed CLO fund?

CLOs are one asset class that we feel is crucial for investors to take an active approach. Replicating an index of CLOs is incredibly difficult. In addition, the asset class is not homogenous and there are significant opportunities to add value through security selection and top-down positioning. But you need specialized knowledge and experience to identify these opportunities. Keep in mind that just one single CLO can have over 300 underlying loans. You need a manager who can drill down and analyze the portfolio at the individual loan-level, in addition to analyzing the CLO manager and understanding and stress-testing the structure itself.

How do you address liquidity concerns in stressful market conditions?

Given the ability for investors to redeem daily in an ETF, liquidity is absolutely a key consideration in structuring the portfolio.

The CLO market has grown significantly and is now over $1.2 trillion in size, which is similar in size to the U.S. high yield market. There is a very active secondary market, and we see a high degree of liquidity particularly in senior tranches. The market has been tested several times in recent years, including COVID and just last year when U.K. liability driven investment (LDI) strategies became forced sellers. In that instance, LDI managers chose to sell senior tranches in size because that’s where they were able to get liquidity, and they found plenty of demand from other investors. Accordingly, we have confidence that there is sufficient liquidity in the CLO market and our focus on investment grade tranches means we are focusing on the most liquid part of the capital structure.

Has CLOI experienced any defaults?

No, the portfolio has not experienced any defaults, and the risk of default losses when investing in senior CLO tranches is very low due to structural protections and the nature of the underlying loans. The strong historical performance of CLOs is a testament to the built-in risk protections of CLOs, which starts with the nature of its underlying collateral. Leveraged loans (the underlying collateral of CLOs) are senior secured, meaning they have the senior-most claim on all the issuer’s assets in the event of a bankruptcy. Historically, leveraged loans’ senior secured status has resulted in lower loss rates compared to unsecured high-yield bonds.

In addition to the attractive risk profile and active management of its underlying collateral, the structure of CLOs helps mitigate risk. For example, investment grade tranches benefit from subordination provided by more junior tranches, and various collateral tests help to ensure high overall credit quality of the portfolio and that more senior tranches get paid before junior tranches if the underlying loan portfolio deteriorates in quality.

As a result, default risk is not the primary concern when investing in senior CLO tranches. You would need to experience default rates in the underlying loan portfolio that are several multiples of the long-term average for multiple consecutive years in a row to have a first-dollar loss even in BBB rated CLOs. That being said, investors need to understand that there is spread risk and downgrade risk which can be driven by deterioration in the underlying loan portfolio, which can result in mark-to-market losses in periods of volatility. This can be mitigated by scrutinizing the underlying loan portfolio to make sure there is comfort with the underlying issuers and sector exposures, and through careful manager selection.

Why do you think there is such a significant interest in CLOs currently?

The combination of high yields, absence of rate risk, and structural features providing insulation against deteriorating credit fundamentals makes CLOs highly attractive. Their performance as a fixed income asset class, especially considering risk-adjusted returns, has piqued investor interest.

We believe income investors can benefit from a portfolio that provides a diversified income stream that provides an attractive return relative to the degree of risk taken. As we have written about previously, CLOs are not simply a hedge against rising rates, although like all floating rate asset classes, investors have benefited in the current environment. Because they provide higher spreads than similarly rated corporates and provide built-in risk protections, they have historically provided high levels of income for a lower level of risk. As a result, more investors are considering a strategic position in CLOs within a core bond portfolio – not just in times of rising interest rates.

^* 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.

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