Will CLOs Continue to Rally in 2024?

The VanEck CLO ETF (CLOI) returned 2.06% in the fourth quarter, and 9.37% for the year, outperforming investment-grade bonds and AAA-rated CLOs, but underperforming the broad CLO market due to its lower risk exposure during the period. CLOI remains conservatively positioned but has modestly increased exposure to AA CLOs in Q4. CLOI had approximately 70% exposure to AAA rated CLOs and 28% to AA CLOs in December vs 70%/12% in the benchmark. Security selection continues to be a key source of return given tighter valuations and risks tilted to the downside. CLOI remains positioned higher in the capital stack but has begun seeing attractive entry points in lower-rated tranches. Should the backdrop begin to improve within the next six months as we currently anticipate, we would begin to add BBB and below investment grade rated classes to the Fund.

Market Update

CLOs continued to rally to end the year, along with nearly all other risk asset classes, as bullish investor sentiment from November continued and accelerated into December. The combination of tighter spreads and lower Treasury rates led to strong total returns for most fixed income asset classes. The Fed strengthened its pivot language, with Fed Chair Powell’s press conference incorporating more reminders of its dual mandate. This unexpected pull forward in the Fed’s assessment of inflation from sticky to mission accomplished, subject only to a couple more months of confirmation, alters the conditions under which rate cuts may now occur. If the Fed is correct in its assessment that sticky core inflation has been broken, it opens the door for a more constructive 2024, with the possibility of a strong US economy alongside rate cuts.

CLOs generated strong total returns across the capital stack in 2023. However, CLOs underperformed bank loans as well as fixed-rate high yield bonds during the year as Treasury yields declined, but outperformed investment grade corporates.

Source: JP Morgan and ICE Data Indices as of 12/31/2023. 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 by over two-thirds month-over-month, with $4.9bn pricing during the month, following $15.6bn in November. New issuance volume ended 2023 at $116bn, down 10% from 2022. Refinancing (refi) and reset activity picked up in December to the highest combined level since February 2022, with $7.5bn pricing, after $4.2bn in November. 2023 total refi and reset volumes were 3% lower compared to 2022, with refi volumes outpacing 2022 by 5%.

In the secondary market, TRACE supply was slightly lower at $18.2bn from $18.4bn in November. Investment grade volumes decreased to $14.3bn from $15.1bn, while below investment grade volumes increased to $3.9bn from $3.3bn in November. Total BWIC volumes decreased to $4.9bn in December from $5.2bn in November.

The trailing twelve-month default rate within the Morningstar US Leveraged Loan Index increased to 1.53% in December, up from 1.48% in November, with one new default. We anticipate the default rate to remain below historical averages in the near term for the leveraged loan market. However, our expectations are that defaults will increase to 3-4% later in the year, above the long-term historical average of ~3%.

CLO fundamentals were mostly flat to improved month-over-month and US CLO spreads were tighter or flat across the capital stack over the month.

Portfolio Strategy

The borrowing rate for leveraged loan borrowers has risen alongside rate increases from central banks over the last two years. 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 if companies are unable to refinance outstanding debt as maturities come due. However, futures markets are now pricing in 5-6 rate cuts from the Fed for 2024 following recent dovish comments. Were this to come to fruition, it could provide relief to more stressed loan borrowers.

Throughout 2023, we looked to benefit from continued increases in interest rates, allowing for increased coupon income. Given expectations for the pace of downgrades to pick up into 2024, we continue to position portfolios 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, with the value proposition moving even more in favor of primary issues as the secondary tightened materially since the end of the third quarter. While our preference is currently for primary issuance, we continue to find attractive opportunities in the secondary market, where purchases below par provide attractive positive convexity.

CLOI Total Return and Credit Allocation

Source: FactSet, JPMorgan, VanEck, As of December 31, 2023. Index performance is not representative of Fund performance. It is not possible to invest directly in an index.

Outlook Ahead

The economic outlook in the United States appears more promising than most expected at the beginning of 2023. A resilient consumer, tight labor market, and moderating inflation have bolstered economic conditions. Issuer fundamentals are still solid but with expectations for a deterioration as the lagged effects of restrictive monetary policy take hold. The Fed has signaled the end of its tightening cycle but will likely maintain higher rates during 2024.

A key trend emerging as we head into 2024 is a pickup in tail risks. In the US, these include concerns that if the Fed keeps rates higher for longer than we think prudent, it may create an unexpected “break” in the economy or markets, and history has shown that easing cycles rarely follow a smooth downward glidepath. The US also faces the risk that a fiscal policy impasse or political gridlock will dial up uncertainty and volatility in markets. In other areas of the world, risks are emanating from the ongoing geopolitical conflicts. The potential for regional spillover and unforeseen fall-on effects adds considerable uncertainty to the global outlook.

Within the CLO market, new issuance picked up significantly in the last few months of 2023 bringing issuance to $116bn for the year, as managers looked to take advantage of tightening liability spreads, a trend we expect to continue to start the year given current spread levels. Despite the higher-than-expected supply, CLOs continue to see strong demand given high all-in yields and spreads are now at or near the tights of 2023. There was also a material pickup 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. However, given the dispersion seen in the loan market, certain CLO portfolios holding weaker credits may eventually experience impairments to the lowest rated debt tranches, even if the majority of the loan market continues to rally. As a result, vintage, portfolio, and 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. New issuance is likely to remain lower than prior years given the arbitrage challenges, although this pressure has lessened materially over the past several months. This should limit the potential for any extreme spread widening in the near term. Given tighter valuations and risks tilted to the downside, we remain positioned higher in the capital stack. However, we are beginning to see attractive entry points lower in the capital stack. Should the backdrop begin to improve within the next six months as we currently anticipate, we would begin to add BBB and below investment grade rated classes to portfolios.

^* 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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Originally published 25 January 2024.

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