It’s not just stocks or rates. Corporate debt markets have also been “yippy” lately. And one corner to keep an eye on are exchange traded funds that invest in collateralised loan obligations.
CLO ETFs have exploded in popularity over the past couple of years, with aggregate assets across the handful of funds surging to $30bn — about 13 times the $2.3bn they held at the end of 2022 — as investors lapped up their punchy yields. About half of it has gone into Janus Henderson’s JAAA ETF alone, which invests in the top-notch triple-A rated slices of CLOs.
However, a few cracks are starting to appear in the market, after investors pulled a record $1.8bn from the funds in the week to Thursday, according to Morningstar data. As Todd Rosenbluth at TMX VettaFi points out, its part of a broad retrenchment:
We have seen anything that is not Treasuries in fixed income fall out of favour with investors, whether it is taking on credit risk through high-yield bonds, senior loans or CLOs. Investors are just hunkering down. JAAA has been one of the hottest ETFs in the past year and a half, but it’s inevitable that people pull back their exposure when the environment shifts.
But CLO ETFs are particularly interesting. Let’s back up a bit to explain why Alphaville is so curious about how these funds are faring.
CLOs are constructed out of floating-rate corporate loans, often to private equity-backed companies, typically with non-investment grade BB or B credit ratings. The loans are then bundled up into pools of debt, and then securitised.
This allows the CLO manager to slice the pools into tranches with varying degrees of risk, which can then be sold to investors. Through the magic of securitisation and over-collateralisation, most of these junky loans can be transformed into a triple-A rated security perfect for risk-averse but yield-hungry pension plans or insurers.
More recently, they’ve become a big hit with retail investors, thanks to the Federal Reserve’s rate increases since 2022 juicing the returns of their floating-rate loans.
It’s no secret why the air has now come out of CLO ETFs. Although no AAA-rated CLO — the tranche favoured by most ETFs — has ever defaulted since their introduction in 1997, fears over defaults make anything with a whiff of credit risk look dicier. Moreover, growing expectations of Fed rate cuts damp the attraction of floating-rate debt.
Matthew Bartolini, head of SPDR Americas research at State Street Global Advisors, points out that investors had also been overweight credit coming into the crisis and valuations were “priced for perfection”, rendering them vulnerable to any wobble.
They are credit instruments. While they may be, in some respects, high up in the capital structure given their securitised nature, there’s still a credit component and what we are seeing is a sell-off in credit assets,
The wave of selling of CLOs by ETFs has exacerbated the difficulties some private equity groups are facing in finding buyers for their debt, with bond sales to finance buyouts made by companies backed by Apollo and Patient Square Capital grinding to a halt.
But for Alphaville, the more relevant issue is how they perform in a choppier environment. These CLO ETFs weren’t around for the big fat March 2020 stress test, and there have long been questions about how they’d fare in a similar crisis.
Even junk bond ETFs invest in fairly actively-traded public securities. CLO tranches and CLO loans, on the other hand, are essentially private credit, making both cash and in-kind redemptions a bit tricky. In Europe regulators have been particularly circumspect, only allowing the first European CLO ETF to list in September.
And lo, the wave of selling has led some funds to trade at chunky discounts to the value of their underlying assets — something that the ETF arbitrage mechanism is supposed to prevent.
Average discounts to net asset value topped 1 per cent at the start of the sell-off, from a premium of 0.04 per cent a day earlier, Morningstar data show, with the $94mn VanEck AA-BB CLO ETF falling to a discount of 4.4 per cent and the $139bn Eldridge AAA CLO ETF one of 3.7 per cent.
But this wasn’t just an issue for the smaller CLO ETFs. Even JAAA, by far the biggest, traded at a discount of 1.1 per cent as investors pulled a record $1.3bn from it.
This is despite actual investment losses being relatively muted at this stage. JAAA’s share price is down 1.3 per cent this month, the Eldridge ETF 0.8 per cent and the VanEck vehicle 2.3 per cent (although losses have been larger for some lower credit quality funds, with an Eldridge ETF targeting BBB to B-rated debt losing 3.1 per cent). Discounts have since narrowed but remain wider than normal.
However, rather than this signifying a problem with the ETFs themselves, some — eg, FTAV’s Robin — believe the blowout in discounts is more a reflection of the underlying security prices being stale and out of date, a phenomenon seen in the wider corporate bond market in March 2020 at the beginning of the Covid-19 pandemic.
“The underlying bonds inside an ETF are not priced real time, whereas the ETF is, so during times of market uncertainty you might see discounts to NAV,” says Rosenbluth.
ETFs give real-time price transparency. It takes time for the bond market to catch up. If you don’t need to trade, don’t trade during times of market volatility because there will be discounts during market sell-offs.
Perhaps. But it will be interesting to see how these CLO ETFs hold up if the turbulence in credit markets escalates further.
Further reading:
— ETFs are eating the bond market (FTAV)