Portfolio Analytics Wrap: CLO ETF Holdings Showcase Stronger Credit Fundamentals Than Market Average

 

Leveraged loans in CLOs that are held by exchange traded funds, or ETFs, have stronger credit fundamentals than the U.S. market average, according to a study of Octus’ Portfolio Analytics data. While the trend is true across the range of ETF products, loans in the CLOs held by mezzanine ETFs had the strongest metrics overall, ahead of the portfolios of CLO ETFs focused on the top of the capital stack.

2024 was a banner year for CLO ETFs, which are a relative newcomer among the CLO investor base, with the first products launching in 2020. Assets held in CLO ETFs recently surpassed $30 billion, and managers’ strategies have evolved to encompass private credit and European CLO tranches in addition to the more established funds that hold CLOs backed by U.S. broadly syndicated loans.

But amid the current macroeconomic uncertainty and volatility across risk assets, these funds have begun to experience outflows for the first time, and the impact of outflows on the CLO tranche market remains an untested and much discussed phenomenon.

Octus, formerly Reorg, analyzed the fundamentals of CLOs held by 13 ETFs in the U.S. market, which totaled $29.62 billion in assets under management as of April 1.

The leveraged loan portfolios of CLOs held in ETFs recorded higher revenue growth (6.53%) than the U.S. market average of 6.3% across all CLO holdings. The loans held by CLOs in ETF portfolios also have higher interest coverage ratios (2.97x) than the market average (2.92x) as well as higher debt repayment capacity (2.41x versus 2.27x).

Meanwhile, the leveraged loans in CLOs held by ETFs have lower first lien net leverage (4.06x) and net leverage (4.82x) on average than the market average (4.12x and 4.9x, respectively).
 

CLO ETFs offer investors daily liquidity, and as such, managers tend to favor investments in the largest CLO issuers, which are typically considered “tier one” by the market, because these names are the most liquid and can be more easily sold when the funds experience outflows.

“Our overall risk framework starts out with bigger, more liquid, tier-one managers that manage more for the debt, and better credit fundamentals are the ramification of this,” said John Kerschner, head of U.S. securitized products at Janus Henderson and portfolio manager of two Janus CLO ETFs, the $21.22 billion Janus Henderson AAA CLO ETF, or JAAA, and the $1.73 billion Janus Henderson B-BBB CLO ETF, or JBBB.

“We try to make sure the portfolio is as liquid as possible,” Kerschner added. “People really care about liquidity. These big asset allocators want to be able to trade in and out without a lot of friction, and they want the transparency of ETFs, like what the holdings are.”

Triple-A CLO ETFs pick credits cautiously. Edwin Wilches, co-head of securitized products and managing director at PGIM, told Octus that the $3.04 billion PGIM AAA CLO ETF, or PAAA, he manages has 99% of its assets held in senior triple-A tranches.

“We don’t let the market dictate how much risk we should take,” said Wilches. “As markets get tighter, if you’re trying to deliver the same return, you have to go down and risk more. We don’t think that’s the best way to manage these funds. You’re supposed to be disciplined around relative value, and there’ll be periods of volatility, and then you make up some of the undercarry with total return,” said Wilches.

Octus also compiled the credit fundamentals data of four mezzanine CLO ETFs against nine AAA funds. The mezzanine group, containing three BBB-B ETFs and one AA-BB ETF, demonstrated stronger credit fundamentals than the AAA counterparts.

Specifically, the mezzanine CLO ETF group has higher revenue growth (6.83%), interest coverage ratio (3.02%) and debt repayment capacity (2.54x) on average than the AAA group (6.4%, 2.95% and 2.35x, respectively.) Meanwhile, the mezzanine ETFs have lower first lien net leverage (4.01x) and net leverage (4.77x) on average than the nine AAA ETFs (4.08x and 4.85x, respectively.)
 

“The weighting is different between JAAA and JBBB. Liquidity is most important for JAAA but not as big for JBBB,” Kerschner said.

“Sometimes we will make the trade-off with JAAA where we will take a little ‘credit metric risk’ because we are getting that extra liquidity, but with JBBB, we are not really willing to make that trade-off. It’s more of a credit product, so we want to make sure that we’re optimizing more on the credit metrics,” Kerschner added.
 

 

In March, CLO ETFs experienced outflows that endured over a sustained period for the first time. According to Barclays research, triple-A ETFs had $650 million withdrawn in the past two weeks, while mezzanine CLO ETFs had outflows amounting to $423 million in the last three weeks of last month, which represented about 10% of the assets held in the funds.

Although the $30 billion CLO ETF market remains a small portion of the total investor base, sources told Octus that they acted as the “incremental buyer” of CLO triple-A tranches during 2024. As such, syndicate bankers would track inflows into the ETF market and tighten spreads in the knowledge that they had a ready buyer. Sources say that this practice became more prevalent after JAAA surpassed $15 billion in AUM and began participating more in the primary market.

With CLO ETFs driving spreads tighter in 2024, with flows now reversed, market participants believe these funds have quickened the pace of spread widening.

Ian Gilbertson, co-head of U.S. CLOs at Invesco, which manages the $366 million Invesco AAA CLO Floating Rate Note ETF, or ICLO, said that ETF demand has kept secondary market spreads tight of primary, noting that a tier-one manager could have seen its triple-A debt trade inside of 80 bps at the start of the year, during a time when the same manager’s paper was priced at 125 bps in the primary market.

“If the secondary market was 80 bps, that tier-one manager’s new issue at 125 looked really attractive,” Gilbertson said. “That enticed a lot of buyers to move to primary and drove spreads to 110. Since February, triple-As have backed up to almost where they were at the start of the year.”
 

PGIM’s Wilches said the outflows in triple-A ETFs are “manageable” because they have been small relative to the inflows that preceded them. “We’re used to understanding that the market sometimes gives and sometimes takes, and we make sure that our portfolios reflect appropriate liquidity.”

But he pointed out that the flows in the mezzanine ETFs receive less focus because they are perceived to be smaller, but the impact of outflows on the triple-B market has been outsized.

“We’ve seen credit curves steepen, meaning that some of the triple-Bs have actually widened a lot, and prices are down more than triple-As. But that is going to have a much bigger impact, as the size of the triple-A market is about 13 times bigger than triple-Bs,” Wilches said.

Some investors have rotated out of CLO ETFs into other types of product within the ETF space. “There are some investors who want to add to duration in the portfolio, trade on JAAA and move into one of our other ETFs, either JSI or JMBS,” Kerschner said. “We had our second-biggest month of inflows into JMBS, which is our actively managed mortgage-backed securities ETF.”

“The outflows from JAAA are not big in the grand scheme of things. We were still the eighth-largest inflow among all ETFs in the first quarter,” he added.