CLO Strategy Selectively Adds Risk Amid Rally

The VanEck CLO ETF (CLOI) shifted modestly into lower investment grade tranches over the quarter. This adjustment followed the tightening of the spread at the top of the capital stack since summer of 2023. The Fund reduced its AAA exposure to 37% and increased its allocation to AA, A and BBB rated CLOs to 38%, 9% and 17%, respectively. Higher conviction in a stable economic environment and strong technicals allow the Fund to benefit from higher spreads in lower rated tranches, while staying positioned overall at the top of the capital stack. Should more attractive entry points emerge lower in the investment grade portion of the capital stack within the next six months, as we currently anticipate, we would shift further down in the cap stack and look to add below investment grade rated classes. But given expectations for the pace of downgrades to pick up into the second half of 2024, we remain very selective when investing in mezzanine tranches. The Fund performed in line with its benchmark in Q1.

Market Update: CLO Rally Continues

In March, CLOs rallied across the capital stack for the fifth consecutive month alongside better-than-feared earnings and continued strong demand as all-in yields remain high. In the US, inflation surprised higher for the second consecutive month in February. Expectations are for the path of inflation to continue its downward trajectory, though inflation has proven stickier than many had anticipated. While the Fed indicated they believe cuts will likely be appropriate at some point this year, sticky inflation alongside strong growth and a resilient consumer has resulted in a data dependent Federal Reserve that would indicate inflation is on a sustainable path towards their 2% target. Alongside hotter inflation, market expectations for rate cuts continue to be pushed back with only 2 rate cuts now priced in for 2024.

CLOs generated strong total returns across the capital stack in Q1, driven primarily by carry, outperforming investment grade corporates and fixed rate high yield bonds, while high rated CLOs underperformed leverages loans.

Source: JP Morgan and ICE Data Indices as of 3/31/2024. 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.

The supply of new CLOs decreased month-over-month, with $15.3B pricing during the month, following $19.8B in February. New issuance volume is now 42% higher than the first quarter of 2023. Meanwhile, refinancing and reset activity accelerated in March, with $19.5B pricing, after $15.2B in February. Year-to-date total issuance of $86.8B is now 156% higher than the same period last year.

In the secondary market, TRACE supply decreased month-over-month to $18.4B from $19.6B in February. Investment grade volumes decreased to $13.5B from $15.7B, while below investment grade volumes increased to $4.9B from $3.9B in February. Total BWIC volumes decreased slightly to $4.4B in March from $4.5B in February. Despite the decrease month-over-month, TRACE and BWIC volumes remained at healthy levels.

The trailing 12-month default rate within the Morningstar US Leveraged Loan Index decreased to 1.14% in March from 1.41% in February, with only one new default. In contrast, distressed exchange activity continued at a brisk pace, 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, our expectations are that defaults, including distressed exchanges, will increase to 3-4% later in the year, above the long-term historical average of ~3%.

CLO fundamentals were mixed month-over-month. On the positive side, exposure to CCC/Caa rated credits decreased to 6.1%/4.5% from 6.2%/4.6% and the OC cushion increased 11bp to 393bp. Meanwhile, exposure to loans pricing below $80 increased 0.3% to 4.0%, and the weighted average spread decreased 1bp to 366bp.

Portfolio Strategy: Modest Shift to Lower Investment Grade Tranches

The borrowing rate for leveraged loan borrowers has risen alongside rate increases from central banks over the last two years. 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 means 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. This may lead 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. While another hot inflation report for March and more recent hawkish comments from the Fed have moved back the timeline for eventual rate cuts, the expectation remains that multiple rate cuts are likely to occur throughout the year. Were this to come to fruition, that could provide relief to more stressed loan borrowers.

Given spread tightening at the top of the capital stack since the middle of last year, we have been shifting portfolios into lower investment grade tranches. Given expectations for the pace of downgrades to pick up into the second half of 2024, we remain very selective when investing lower in mezzanine tranches. Were spreads to widen, we maintain the ability to shift further into lower rated tranches. Given the rise in CLO paper trading above par, we continue to realize gains for AAA rated securities that are trading above par in favor of AAs and selective A and BBB rated credits, which offer more positive price convexity and/or spread. Despite recent shifts, portfolios remain primarily positioned in the top part of the capital stack (AAA/AA/A), which buffers investors from lower tranche downgrades or losses at the equity tranche level.

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. CLO issuance has become more attractive as the arbitrage improved with lower liability costs, leading to the fastest pace of primary issuance to start a year on record. While our preference is currently for primary issuance, we continue to find opportunities in the secondary market, where purchases below par provide positive convexity, which may be attractive as interest rates fall.

CLOI Total Return and Credit Allocation

Source: FactSet, JPMorgan, VanEck, as of March 31, 2024. Index performance is not representative of Fund performance. It is not possible to invest directly in an index.

Outlook Ahead: Base Case for Stability Ahead

Despite the lack of change in tight valuations, we have greater conviction in the base case for a stable economic environment ahead. This is further underpinned by the Fed’s affirmation of maintaining its rate cut outlook for 2024, despite a revision upward of inflation expectations and overall economic strength. Greater economic confidence is also resulting in a stronger technical backdrop, as investors continue to seek credit based on attractive overall yields rather than tight spreads. Therefore, despite rich spread valuations which would call for higher caution, there isn’t a need to be uber-cautious as downside economic growth probabilities decline further.

Within the CLO market, new issuance has started the year at a record pace, as managers take advantage of tightening liability spreads. This may continue in the near term given current AAA spreads at the tightest levels since early 2022, but this pace may be unsustainable given the lack of net new loan issuance 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 at attractive levels given more muted rate cut expectations. 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 the rally in the loan market and tighter CLO spreads. 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. 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, even if the majority of the loan market continues to rally. As a result, vintage, portfolio and manager selection remains key.

We anticipate CLO spreads to trade in a range for the next 3-6 months and see spreads and yields attractive under most market scenarios over the next 12 months. We also expect the CLO market to continue to be supported by a strong technical backdrop. Notwithstanding the deluge of new issuance to start the year, we do not expect issuance to approach 2021 or 2022 levels, unless there is a material pickup in net new loan issuance. This should limit the potential for any extreme spread widening in the near term. Given tighter valuations and risks tilted to the downside, we remain positioned higher in the capital stack overall. However, we have taken advantage of selective attractive opportunities at the BBB level and continue to look for attractive entry points lower in the investment grade portion of the capital stack. Should the backdrop begin to improve within the next six months, as we currently anticipate, we would shift lower in the capital stack and look to add below investment grade rated classes to the portfolio.

^* 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 expense ratio for CLOI is 0.4%.

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.

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