The VanEck CLO ETF (the “Fund”) outperformed its benchmark, the J.P. Morgan CLO Index, in the first quarter by 0.47%, and since launching in June 2022 has outperformed by 1.07%, driven by both top-down portfolio positioning by quality and bottom-up security selection. The Fund has achieved performance that is in-line with the BBB-rated subset of its benchmark with a much higher quality tilt (currently nearly 100% of the Fund’s portfolio is rated AAA or AA, with no holdings below A), as well as significant outperformance versus the AAA subset.
Market Update: Collateralized Loan Obligations (CLOs) generated negative total returns in March as turmoil in the US regional and European banking sectors led to an increase in volatility in both US Treasury rates and risk asset classes, but were up for the quarter. Concerns around banking stability metastasized into other segments of credit, which led to a slowdown in capital market activity. Despite initial concerns that the failures of Silicon Valley Bank and Signature Bank could be the beginning of a more systemic banking contagion, the US Treasury and Federal Reserve took significant steps to guarantee depositors at these failed banks would remain whole and would backstop deposits at other US banks that may experience a contagion effect, helping to calm investor nerves and bring stability back to markets. CLOs rallied towards the end of the month as markets calmed following these actions; however, it was not enough to offset earlier losses. In the face of these challenges, the Fed increased the Federal funds rate by 25 basis points (bps) at its March meeting amid prolonged elevated levels of inflation and a robust labor market.
|Investment Grade Corporates||3.45||5.25||145|
|High Yield Bonds||3.72||8.49||458|
Source: JP Morgan and ICE Data Indices as of 3/31/2023. 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.
Per Barclays Research, CLO new issue supply decreased month-over-month, with $11.0bn pricing during the month compared to $15.7bn in February. However, year-to-date new issuance of $33.6bn is outpacing year-to-date activity in 2022 and is the second highest on record behind 2021. Refinance and reset activity remained muted with just $0.4bn pricing in March. In the secondary market, TRACE supply was marginally lower at $14.9bn from $15.0bn in February, per Morgan Stanley. Investment grade volumes were roughly flat at $11.8bn while below investment grade volumes decreased to $3.1bn from $3.3bn.
There were three new defaults in the Morningstar U.S. Leveraged Loan Index in March. As a result, the trailing twelve-month default rate by principal increased to 1.32% from 1.02% in February. We anticipate the default rate to remain below historical averages in the near term for the leveraged loan market, notwithstanding ongoing interest rate increases and indications that Fed hikes will maintain higher interest rates throughout 2023. We anticipate the default rate to increase and our expectations are that defaults will increase in 2023-2024 period to 3%-4%, above the long-term historical average of roughly 3%.
From a fundamental standpoint, credit metrics were mostly rangebound to worsened, while market value metrics suffered during the month.
Portfolio Strategy: Playing Safe and Smart Continues to Outperform
The Fund returned 2.45% for the first three months of the year, outperforming its benchmark, the J.P. Morgan CLO Index by 0.47%. The Fund shifted within investment grade buckets during the quarter, by increasing exposure to AAA-rated CLOs mid-quarter. The Fund had over 75% of its holdings in AAA-rated CLOs as of March 31, 2023. This top-down positioning by rating bucket was a positive driver of outperformance in the quarter, as was security selection which contributed approximately equally to outperformance. The portfolio also benefited from its spread duration positioning throughout the quarter.
As central banks increased rates in 2022 and have continued to increase thus far in 2023, the borrowing rate for leveraged loan borrowers is anticipated to continue rising. Rating agencies are vigilant and the increased borrowing costs for borrowers means that interest coverage ratios have declined and will continue to do so. As companies report pressures on earnings, borrowers’ financial positions continue to weaken with higher leverage and lower interest coverage ratios, leading to the risk of downgrade.
As we expect the pace of downgrades to pick up in 2023, we continue to position portfolios conservatively, with the ability to shift into lower-rated tranches as the year progresses. For the start of 2023, we looked to benefit from continued increases in interest rates, allowing for increased coupon income. 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. However, we find much of the secondary market attractive as spreads have widened back to levels from the start of the year and purchases below par provides for attractive positive convexity.
CLOI Total Return and Credit Allocation
Source: JP Morgan and Morningstar as of 3/31/2023. 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.
Outlook Ahead: Still Waiting to Add Risk
Despite the second and third largest failures in US banking history with Signature and Silicon Valley Bank, larger banks remain well capitalized for the time being and are unlikely to face liquidity issues. Deposits are moving to the larger banks and to money market funds as a result. More broadly, this is another example of the underlying stresses we are seeing emerge due to the pressure of higher rates and shrinking global central bank balance sheets. This combination of stresses has created an environment of heightened depositor concern and higher cost of capital for all banks regardless of size. This has the effect, in our opinion, of further tightening financial conditions in a manner that may slow economic growth more than that has already been imposed by central bank policy.
The team remains of the view that economic growth and corporate earnings will slow over the coming quarters. However, we envision a variety of scenarios, most of which indicate yields and credit spreads will trade flat to wide of current levels before ultimately tightening. While these events decrease the likelihood of high growth scenarios, they do not necessarily result in a classic recession that would materially elevate credit risk. While we believe that the overall health of the US banking sector is robust, we acknowledge that it is an industry that relies very heavily on depositor confidence and that some amount of uncertainty will remain.
At some point, central banks will pause or even pivot, with the market currently pricing in one last increase in May, and interest rates will decline. At that time, we anticipate credit spreads to tighten. This will allow for portfolios constructed with purchases in the secondary market to benefit from the significant redemption optionality in CLOs, which will be refinanced, reset, or outright called once the leveraged loan market recovers in price and CLO spreads tighten. As CLO tranches are priced to worst, the yield to maturity, spread, and convexity are underpriced given the optionality to be redeemed prior to maturity.
Against this backdrop, we continue to position portfolios higher in the capital stack, purchasing attractively priced credits in the secondary market and looking to add relative value at the security and manager selection level. We expect that the backdrop will begin to improve during the second half of the year, at which point we would begin to add risk to portfolios.
|1 Month*||3 Month*||YTD||1 Year||3 Year||5 Year||10 Year||LIFE|
|CLOI (Share Price)||-0.31||2.28||2.28||—||—||—||—||5.91|
|J.P. Morgan Collateralized Loan Obligation Index||-0.23||1.98||1.98||—||—||—||—||4.72|
* 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 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.
Originally published by VanEck on April 25, 2023.
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