CLO Returns Driven by Carry and Price Gains

The VanEck CLO ETF (the “Fund”) returned 2.05% in the second quarter of 2024, approximately in line with its benchmark (please see below for standardized performance¹). We have paused further rotation lower in the capital stack as we believe the relative value opportunities have begun to shift, as CLO prices have rallied significantly this year. Tight valuations and dispersion in the loan market argue for a bottom-up approach to identify opportunities to take advantage of currently elevated yields while avoiding CLOs with weaker credits. Vintage, portfolio and manager selection remain key. We maintain the ability to shift further into lower-rated tranches when the risk/reward profile becomes more favorable.

• Market Update
• Portfolio Strategy
• Outlook

Market Update: Strong CLO Total Returns

CLOs generated positive total returns in June, the 15th consecutive month of positive returns at the overall index level. CLO returns were positive across the capital stack for the eighth month in a row. Carry continues to drive strong returns given high base rates, while price returns were negative. The macroeconomic environment was supportive during the month with the market pricing for somewhere between Goldilocks conditions and a mild economic slowdown. Treasuries rallied on the back of a very favorable US CPI report, weaker economic data, political unrest in France, and Fed projections suggesting a delayed but not necessarily less substantial easing cycle. Treasury rates rallied in June, with 5- and 10-year Treasury rates trading 13 bps and 10 bps lower, respectively.

CLOs generated strong total returns across the capital stack in Q2, driven primarily by carry, outperforming investment grade corporates, fixed rate high yield bonds and leveraged loans.

Source: JP Morgan and ICE Data Indices as of 6/30/2024. CLOs represented by J.P. Morgan Collateralized Loan Obligation Index CLOs IG represented by J.P. Morgan Collateralized Loan Obligation IG 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 slowed month-over-month, with $11.2bn pricing during the month, the lowest monthly volume of the year, following $24.0bn in May, which was the highest monthly volume since November 2021. New issuance volume is now 80% higher than year-to-date 2023 and is the fastest pace on record. Meanwhile, refinancing and reset activity continued at a torrid pace in June, with $29.3bn pricing, after $23.5bn and $20.3bn in May and April, respectively. Year-to-date total issuance of $212.3bn is now 276% higher than the same period last year.

Gross institutional loan issuance continued at a brisk pace in June, with $53.9bn pricing, after $51.0bn priced in May. Issuance was still driven by repricing and refinancing transactions. Issuers remained focused on reducing borrowing costs and pushing out maturity walls. The technical supply-demand shortage persisted for another month despite a decline in net demand. Net inflows for retail loan funds declined to $804 million, down from $3.0bn last month.

The trailing twelve-month default rate within the Morningstar US Leveraged Loan Index decreased to 0.92% in June from 1.08% in May. In contrast, as measured by JP Morgan, the default rate including distressed exchanges is 3.10%. This shows that activity has been elevated as borrowers with unsustainable capital structures endeavored to manage their liabilities and avoid the bankruptcy process. We anticipate the default rate to remain below historical averages in the near term for the leveraged loan market. However, we expect that defaults, including distressed exchanges, will remain in the 3-4% range, above the long-term historical average of ~3%. CLO fundamentals were mixed month-over-month.

Average Annual Total Returns* (%) Quarter End as of 06/30/24

^* Returns less than one year are not annualized.

¹ CLOI Performance as of 6/30/2024.

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.

CLOI’s total expense ratio 0.40%. 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, 2025. “Other Expenses” have been restated to reflect current fees.

Source: FactSet, J.P. Morgan, VanEck, as of June 30, 2024. Index performance is not representative of Fund performance. It is not possible to invest directly in an index.

Portfolio Strategy

The borrowing rate for leveraged loan borrowers remains high following rate increases from central banks over the last two years. While there have been signs of softening, 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 mean that interest coverage ratios will continue to decline as the lagged effect of rate increases takes hold. Ultimately, the result will be higher leverage and even lower interest coverage ratios, leading to the risk of downgrade if companies are unable to refinance outstanding debt as maturities come due or grow revenues from a more robust economic environment. Market expectations with respect to Fed easing for the year have been reset, with two rate cuts now priced in for 2024, starting in September. Cuts will provide relief for more stressed borrowers.

CLO prices have rallied significantly this year with the average AAA-BBB price ending June above par, with the basis between higher and lower-rated tranches tightening through the 5-year median. As a result, we have paused any further rotations lower in the capital stack as the relative value opportunities have begun to shift. Were spreads to widen, we maintain the ability to shift further into lower rated tranches. With the majority of CLO paper trading above par, we continue to realize gains in securities that are trading above par in favor of credits, which offer more positive price convexity and/or spread in the primary market.

Primary and secondary spreads tightened to start the year. However, buying in the primary market continues to allow for wider spreads on a relative basis, even when taking spread duration into account.

Overall Defensive While Selectively Adding Risk

Source: FactSet, J.P. Morgan, VanEck, as of June 30, 2024. Index performance is not representative of Fund performance. It is not possible to invest directly in an index.

Outlook Ahead: CLO New Issuance Expected to Continue

Looking toward the second half, we believe that at the index level, most fixed income risk asset classes are trading through fair value to varying degrees – a critical investment challenge that argues for a bottom-up approach that considers specific subsegments of individual issuers’ attractions or risks. With limited opportunities for spread compression and price appreciation, targeting assets that are poised to return currently elevated yield income, such as CLOs, should produce an attractive outcome. Loan fundamentals have remained stable amid limited leverage-accretive LBO and M&A activity due to prohibitive financing costs. Companies have instead been prioritizing liability management, including extending near-term debt maturities and reducing nominal spreads. Modest, but still positive corporate revenue and earnings growth will buttress fundamentals while stressed credits continue to be impaired by idiosyncratic factors.

Despite limited net loan issuance, CLO new issuance has continued at a record pace as managers take advantage of tighter liability spreads. We expect this will continue in the near term given current AAA spreads are at the tightest levels since early 2022, but this pace may be unsustainable unless M&A and LBO activity picks up. Despite the higher-than-expected supply, CLOs continue to see strong demand given high all-in yields, which we expect to remain the case through year-end. In addition to the traditional investor base which has been a consistent source of demand, the CLO market has benefitted from the growing presence of CLO ETFs. Japanese banks, traditionally big buyers of AAA-rated paper, are also expected to make additional allocations to CLOs which could serve as a tailwind for further spread compression and ultimately additional CLO creation over the back half of the year and into early 2025. We have also seen a material increase in refinancing and reset activity in recent months as portfolios constructed with purchases in the secondary market take advantage of higher loan prices and tighter CLO spreads. This has also bolstered demand for new paper and led to tighter spreads as investors put proceeds back to work. Should the loan and CLO markets continue to rally, we would expect to see more portfolios benefit from the significant redemption optionality in CLOs, although that potential universe has shrunk materially given the level of activity already this year.

Amid the supportive technical environment, we anticipate CLO spreads to trade in a range for the next 3-6 months and we see spreads and yields as attractive under most market scenarios over the next twelve months. 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. As a result, vintage, portfolio, and manager selection remain key. In addition, with tight valuations and risks tilted to the downside, we remain positioned higher in the capital stack overall, maintaining the ability to quickly shift lower in the capital stack should the market experience any bouts of weakness.

Investing in CLOs with VanEck

The VanEck CLO ETF (CLOI), subadvised by PineBridge, may offer an attractive way for investors to efficiently access this market with the liquidity, transparency and low cost features of an ETF. CLOI invests primarily in investment grade CLO tranches and may invest up to 20% in BB-rated CLOs (but will not invest in CLOs rated below BB-/Ba3 or equity tranches of CLOs).

CLOI aims to provide an enhanced yield by identifying the most attractive segments of the CLO market, while avoiding downgrades and default losses. Through our active management, we can move throughout the CLO capital structure to potentially add alpha, adding risk when there are opportunities and de-risking in periods of market volatility.

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