CLOI Defensive Positioning Drives Q3 Outperformance
October 26, 2022
Read Time 5 MIN
CLOs have outperformed most fixed income asset classes year to date, thanks to their floating nature and the increasing level of income generated as short-term rates continue to rise. Spread widening has created relative value opportunities in the space. Further widening is possible from here, and the VanEck CLO ETF (CLOI) remains defensively positioned. CLOI’s positioning contributed to its outperformance relative to its benchmark in the third quarter.
Market Update: CLOs Lead Among Credit Asset Classes
CLOs outperformed investment grade credit, high yield bonds and leveraged loans in September, and CLOs and loans have materially outperformed other credit asset classes in the quarter and year to date (as of 9/30/2022).
|Asset class||QTD Return (%)||YTD Return (%)||Yield to Worst (%)||Spread (bps)|
|Investment Grade Corporates||-5.11||-18.33||5.74||167|
|High Yield Bonds||-0.68||-14.62||9.57||543|
Source: J.P. Morgan, ICE Data Indices as of 9/30/2022. CLOs represented by J.P. Morgan CLO 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. Leveraged loan yield represents yield modelled to a 3-year maturity. US CLO Yield to Worst represents yield to call for premium priced securities or to maturity when priced at a discount to par based on forward reference rates.
Per Barclays Research, CLO new issue supply increased month-over-month following the summer lull, with $13.3B pricing during the month compared to $7.6B in August. Primary issuance is down 19% from 2021 levels. For the third month in a row, no refis or resets priced in September, following just $0.3B pricing in both May and June. Total issuance for the year is now 60% lower compared to YTD 2021. In the secondary market, TRACE supply increased to $16.1B in September from $11.4B in August, per Morgan Stanley. Investment grade volumes increased to $11.8B from $8.4B in August and below investment grade volumes increased to $4.3B from $3.0B. Total BWIC volumes increased to $5.2B from $3.8B in August.
There were two defaults in the Morningstar/LSTA Leveraged Loan Index in September. As a result, the trailing 12-month default rate, by principal, increased to 0.90% from 0.60% in August. We anticipate the default rate to remain below historical averages in 2022 for the leveraged loan market, notwithstanding ongoing interest rate increases and indications that Federal Reserve (Fed) hikes will continue throughout the calendar year. We anticipate the default rate to increase over the medium-term, though our expectations remain that defaults will stay below the long-term historical average of roughly 3%.
CLO fundamentals were mixed month-over-month, with credit metrics remaining fairly stable, while market value metrics were significantly weaker. Per Barclays Research and Morgan Stanley, the junior overcollateralization cushion decreased 1 bp to 495 bps, CCC/Caa buckets increased from 3.6%/3.2% in August to 3.6%/3.3% in September, weighted average rating factor (which measures overall credit quality by rating) remained constant, weighted average spread increased 2 bps to 350 bps, and the exposure to loans priced below $90 and below $80 increased 10.4% to 20.4% and 1.5% to 5.6%, respectively.
Portfolio Strategy: Shifting up the Capital Stack
While CLO metrics remain strong overall, CLO spreads widened to levels last seen during the peak of the COVID-19 crisis in 2020, as ongoing geopolitical and economic risks continue to weigh on market sentiment. Despite their relative strength compared to other fixed income assets to start the year, significant spread widening has created additional relative value opportunities in CLOs in the secondary market. In addition, we believe CLOs will benefit from inflows to the asset class due to very good historical performance of the asset class in increasing default scenarios as well as the floating nature of CLOs. While spreads are at the widest levels of the year, spreads could widen a bit more from here prior to stabilizing. As a result, we continue to shift portfolios higher in the capital stack while adding value via disciplined security selection.
The Fund returned 0.02% in the quarter ended September 30, 2022, outperforming its benchmark, the J.P. Morgan CLO Index, by 0.13%. Outperformance was primarily driven by security selection within the BBB rated bucket. A higher allocation to A and AA rated tranches also contributed positively, as well as an underweight to BB rated CLOs, reflecting currently conservative positioning. The largest detractors from relative performance were selection within the A rated bucket and an underweight to AAA rated tranches.
Outlook Ahead: Uncertainty Drives Defensive Positioning
The outlook for the broader U.S. economy remains unclear. The Fed continues to emphasize the tight labor market as the primary catalyst underlying inflation, so a pivot from the central bank remains unlikely in the near term. Job openings still outnumber unemployment claims, which contrasts with easing inflation in other areas of the economy as measured in business surveys and as is evident in the softening housing market, all of which has exacerbated fears of a policy error on the part of the Fed. The higher probability of a recession has contributed to the volatility in financial markets that are already contending with both higher rates and a dearth of liquidity in the current economic environment. Current conditions will likely persist and frustrate forecasts until additional clarity emerges around where rates will peak.
In this environment, higher-yielding floating rate asset classes like CLOs may provide an attractive return opportunity among credit assets while remaining relatively isolated from geopolitical risks. In addition, we believe demand for CLOs will continue to be robust as negative real rates will continue to incentivize investors to take advantage of the yield pickup and the relative attractiveness of CLOs compared to other credit assets.
However, given the level of uncertainty in the market, we do not believe this is the time for broad risk-on positioning. Instead, we believe additional rallies will provide a good opportunity to further reduce risk and favor our prior stance of maintaining marginally defensive positioning, looking to add relative value at the security and manager selection level.
J.P. Morgan Collateralized Loan Obligation Index (CLOIE) is comprised of US dollar denominated broadly-syndicated arbitrage CLOs.
AAA Rated CLOs represented by J.P. Morgan CLO AAA Index is a subset of the CLOIE index that only tracks the AAA rated CLO.
AA Rated CLOs represented by J.P. Morgan CLO AA Index is a subset of the CLOIE index that only tracks the AA rated CLO.
A Rated CLOs represented by J.P. Morgan CLO A Index is a subset of the CLOIE index that only tracks the A rated CLO.
BBB Rated CLOs represented by J.P. Morgan CLO BBB Index is a subset of the CLOIE index that only tracks the BB rated CLO.
BB Rated CLOs represented by J.P. Morgan CLO BB Index is a subset of the CLOIE index that only tracks the BB rated CLO.
ICE BofA US Corporate Index (C0A0) tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market.
ICE BofA US High Yield Index (H0A0) tracks the performance of U.S. dollar-denominated below investment grade corporate debt publically issued in the U.S. domestic market.
ICE BofA US Broad Market (US00) tracks the performance of US dollar denominated investment grade debt publicly issued in the US domestic market, including US Treasury, quasi-government, corporate, securitized and collateralized securities.
JP Morgan Leveraged Loan Index is comprised of U.S. dollar leveraged loans.
Morningstar/LSTA Leveraged Loan Index is comprised of U.S. dollar leveraged loans.
This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.
An investment in the VanEck CLO ETF (CLOI) may be subject to risks which include, among others, Collateralized Loan Obligations (CLO), debt securities, LIBOR Replacement, foreign currency, foreign securities, investment focus, newly-issued securities, extended settlement, affiliated fund, management, derivatives, cash transactions, market, Sub-Adviser, operational, authorized participant concentration, new fund, absence of prior active market, trading issues, fund shares trading, premium/discount, liquidity of fund shares, non-diversified, and seed investor risks. The Fund may also be subject to liquidity, interest rate, floating rate obligations, credit, call, extension, high yield securities, income, valuation, privately-issued securities, covenant lite loans, default of the underlying asset and CLO manager risks, all of which may adversely affect the Fund.
Investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider the investment objective, risks, charges and expenses of the Funds carefully before investing. To obtain a prospectus and summary prospectus, which contain this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus carefully before investing.
© Van Eck Securities Corporation, Distributor, a wholly owned subsidiary of Van Eck Associates Corporation.
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