CLO ETFs Tested by ‘In-Kind’ Investor Strategies Amid Volatility

Reporting: Diana Bravo, Chloe Wang
Investors in CLO exchange traded funds, or ETFs, have been experimenting with “in-kind” redemptions amid the ongoing tariff uncertainty, according to market sources. The strategy comes as an arbitrage opportunity opens up as these funds undergo their first experience with outflows, and shareholders are swapping their ETF positions for direct investments in CLO tranches to take advantage of more attractive yields.

The CLO ETF model has seen record outflows since President Donald Trump’s announcement of tariffs in early April caused a run for liquidity. Janus Henderson’s market-leading fund JAAA, which has over $20 billion in assets, saw its holdings reduce by 1.1% on April 7, according to Bloomberg.

The bleeding has since slowed. According to Barclays Research, triple-A CLO ETFs saw $335 million inflows last week, while mezzanine CLO ETFs saw $110 million outflows. Mezz ETFs had a brief reprieve during the week of April 14 when they had $54 million inflows, which followed five consecutive weeks of losses.

John Kerschner, head of U.S. securitized products and a portfolio manager at Janus Henderson, manager of both JAAA and the mezzanine CLO ETF JBBB, which mostly buys triple and double-B tranches, said that while his firm’s ETF saw high outflows in April, investors in the ETF were making so-called in-kind redemptions, swapping out their ETF shares to invest in CLO tranches directly. Rather than forced selling, many investors that bought shares by selling CLO positions are now redeeming those shares and swapping them for direct investments in tranches.

“In any given day, we can get hundreds of millions in inflows. Most of those are ‘in-kinds’ so it’s not like we’re really trading them – it’s just dealers trading CLOs for shares or vice versa,” Kerschner said. “That being said, we want to make sure the book is very liquid. We have had that direction since the beginning of JAAA, and it serves us well in markets like this.”

Pratik Gupta, head of CLO research at Bank of America Merrill Lynch, told Octus, formerly Reorg, that a significant portion of the redemptions seen in the CLO ETF space is attributed to in-kind redemptions rather than retail selling.

“This has been happening across the board,” Gupta said. “When we see outflows, they are often based on the number of shares that have been redeemed, which can sometimes create confusion.”

In-kind redemptions are limited to certain dealers. As one source said, “retail investors cannot exchange in-kind due to the structure of the ETF and the minimum denomination requirements.”

Speaking on Octus’ “CLO Market in Flux” webinar, Michelle Manuel, co-portfolio manager at Investec, said that ETFs are a newer entrant to CLO investing and as such they expose the market to the whims of retail investors. With the market experiencing high levels of volatility as a result of tariff uncertainty in the United States, retail investors’ reactivity is exacerbating the volatility in tranches.

“We’ve got a lot more retail investors now,” Manuel said. “Those are the kinds of investors who are going to be more inclined to be reactive.”

Sources say that certain sophisticated investors have spotted an arbitrage opportunity in in-kind trading between ETF shares and CLO tranches, taking advantage of the basis between the net asset value of the CLO held by the ETF and the market price of the ETF share.

Shawn Cooper, a senior portfolio manager at Orchard Global, added on the webinar that the introduction of retail investors can swing the technicals of CLOs and force sales.

“The retail investor base that has really opened up predominantly in the top of the capital structure [has spread] throughout the entire CLO market,” Cooper said. “Their involvement can potentially swing the technicals, exacerbate movements and create potential forced selling that may not exist otherwise.”

Kerschner attributes about 70% to 80% of Janus Henderson’s daily flows since February to in-kind transactions and says his funds are not offloading CLOs en masse. Instead, Kerschner said, ETF stockholders who purchased their stock by contributing CLOs are asking for their initial contributions back, causing the ETF to post outflows.

“The question, then, is ‘What is the street doing with those outflows?’” Kerschner said.

“Sometimes they just hold on to them because they think that as things get cheaper … clients come in wanting to buy CLOs, but there is definitely not this wholesale selling of CLOs out of JBBB.”

Orchard’s Cooper also noted on the webinar that in addition to retail investors, credit investors that are not as familiar with the CLO space can cause further volatility, posing a risk factor to the market.

“You always have general credit investors who look across credit disciplines and happen upon the CLO space … and are attracted to it,” Cooper said. “We’ve seen over the course of the last month and a half how quickly [retail investors] respond to macro events and the largest AAA ETF out there experienced meaningful outflows in a very short period of time that we wouldn’t naturally see with longer term locked up vehicles.”

Despite concerns from various market participants about the impact of ETF outflows on an already volatile environment, Kerschner remains optimistic about opportunities in the less-liquid triple-B market. He pointed out that, by focusing on managers he trusts, he is still able to secure attractive pricing, allowing JBBB to complete transactions despite market turbulence.

“For JBBB, in these types of markets, you want to be buying managers you like,” Kerschner said. “If they have to give up 10 bps, even 20 bps or 25 bps at the bottom of the capital stack, they’re often willing to do that. They’ll often come to us when a deal is 75%-90% done and they just want to clean it up. Often, we can get a nice concession on spreads in these types of markets.”

While the CLO ETF market is still relatively new and has not yet faced significant stress, the ecosystem is holding up, and managers are adapting. Kerschner said that ETFs can trade below their net asset value during market dislocations, but the in-kind redemption mechanism helps prevent the discount from widening too much, as arbitrage-seeking investors will typically step in to correct it.

“The key point is that you can observe the discount in real time, which allows you to make an informed decision on whether to sell or hold.” Kerschner added.