CLOs Continue to Climb As Spreads Tighten and Coupons Rise

The VanEck CLO ETF (the “Fund”) has outperformed its benchmark, the J.P. Morgan CLO Index year-to-date through June 30, 2023 and since the fund launched in June 2022. In the second quarter, however, the Fund’s more conservative positioning detracted from performance amid a rally in risk asset classes. Security selection, however, added to performance and has been the main contributor to outperformance since the Fund launched. Relative value opportunities from security and manager selection remain the focus, while the Fund stays higher in quality. When the market backdrop improves, we expect to add exposure further down the capital stack.

Market Update

CLOs generated the strongest monthly total returns since January, alongside strong performance across most risk asset classes, as investor sentiment improved markedly in June. This came despite a Fed narrative that was more hawkish than many investors’ expectations. Specifically, despite the rate hike pause at their June meeting, the median interest rate dot for 2023 was revised higher to show two more hikes this year with this projection widely held among FOMC participants. On the positive side, the Fed’s preferred measure of inflation came in lower than expected in May. Core PCE rose 4.6% year-over-year, down from 4.7% in April and below economists’ median estimates. The technical backdrop remained supportive as lower new issuance was met by higher TRACE supply, helping to drive secondary CLO spreads tighter. US Treasury rates increased in June, with 5- and 10-year Treasury rates trading 40 bps and 19 bps higher during the month, respectively.

CLOs outperformed investment grade and high yield corporate bonds, as well as core U.S. bonds, during the quarter but underperformed leveraged loans.

Source: JP Morgan and ICE Data Indices as of 6/30/2023. 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. Index performance is not representative of Fund performance. It is not possible to invest directly in an index.

Per Barclays Research, CLO new issue supply decreased over 50% month-over-month, with $4.3 bn pricing during the month compared to $10.5bn in May, the lightest level of primary issuance since August 2020. Year-to-date new issuance of $54.8bn is now trailing year-to-date activity in 2022 by 25%. The first reset since March priced during the month for $0.4bn. Year-to-date refinance and reset volumes of $0.8bn is 97% lower than the first half of 2022.

In the secondary market, TRACE supply was higher at $15.9bn from $14.3bn in May, per Morgan Stanley. Investment grade volumes increased to $12.4bn from $11.8bn and below investment grade volumes increased to $3.5bn from $2.5bn. Total BWIC volumes increased to $4.3bn in June from $4.0bn in May.

There were six defaults in the Morningstar U.S. Leveraged Loan Index this month, increasing the trailing 12-month default rate by par outstanding to 1.71%, from 1.58% in May. 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 the Fed will maintain higher interest rates throughout 2023. However, our expectations are that defaults will increase in 2023-2024 period to 3-4%, above the long-term historical average of about 3%.

CLO fundamentals were mixed month-over-month.

Portfolio Strategy

The Fund returned 2.07% in the second quarter of the year, underperforming its benchmark, the J.P. Morgan CLO Index by 0.36%. The Fund became more conservatively positioned through the quarter, with approximately 85% of the Fund in AAA rated CLOs as of 6/30/2023, which is a 16% overweight versus the benchmark. Similarly, with no exposure to CLOs rated BBB and below, the Fund is underweight lower rated tranches. Although this more conservative positioning detracted from performance during the quarter amid a rally in risk assets, this was partially offset by security selection.

As central banks increased rates in 2022 and have continued to increase thus far in 2023, the borrowing rate for leveraged loan borrowers has risen. However, following the interest rate increase in May, the Fed left the target rate unchanged in June and recent economic releases have created additional uncertainty about the path forward. That said, rating agencies are vigilant and increased coupon payments for borrowers means that interest coverage ratios have declined and will continue to do so during the second half of the year as the lagged effect of rate increases takes hold. As companies report pressures on earnings, borrowers’ financial positions will continue to weaken. The result will be higher leverage and lower interest coverage ratios, leading to the risk of downgrade.

For the start of 2023, we looked to benefit from continued increases in interest rates, allowing for increased coupon income. While below investment grade tranches now seem attractive on an historical basis, the coupon pickup relative to AAA’s doesn’t appear as attractive on a risk-adjusted basis given expectations for the pace of downgrades to pick up during the second half of 2023. As a result, we continue to position portfolios conservatively with the ability to shift into lower rated tranches later in the year when spreads widen. 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, although primary issuance has been low and is expected to remain muted given challenges to the equity arbitrage. We continue to find much of the secondary market attractive as spreads widened over the second quarter, near levels from the fourth quarter of 2022, and purchases below par provides for attractive positive convexity.

CLOI Total Return and Credit Allocation

Source: FactSet, JPMorgan, VanEck, As of June 30, 2023. Index performance is not representative of Fund performance. It is not possible to invest directly in an index.

Outlook

Labor markets and consumer spending remain strong despite persistent, albeit declining, inflation. While there have been improvements in inflation data, the speed to normalization remains a key question. We believe the Fed’s focus will be on addressing lapses in regulatory supervision and reversing the latest temporary surge in its balance sheet. We expect to see Fed balance sheet declines through quantitative tightening despite seeking to pause policy rate hikes. Ultimately, we expect to see higher inflation and yields compared to the last cycle (albeit lower than at present), stemming from tighter labor markets and the splitting of global supply chains as companies address rising geopolitical tensions. However, current Treasury yields now offer a positive real yield, and as inflation belatedly fades from current high levels, a more attractive risk/reward profile for fixed income investors will emerge.

First quarter earnings season started off strong, but lagged as we got into private filers, increasing volatility as earnings season progressed. We expect the economy and corporate profits to slow as the lagged impact of restrictive monetary policy takes hold. We expect default rates to peak in the 3-4% range and then likely stay around that level for some time. We also believe volatility will persist given the likely slowing of the economy in Q4 2023/Q1 2024, which should manifest itself in earnings dispersion for underlying issuers. As a result, manager selection remains key. We expect 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 twelve months. We also expect the CLO market to be supported by the technical backdrop, as we anticipate new issuance to remain muted given the arbitrage challenges. This should limit the potential for any extreme spread widening in the near term.

At some point, central banks will pause or pivot, with the Fed already holding rates steady at their June meeting, and interest rates will decline at some future period, likely Q4 2023 or 2024. 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 in investment grade tranches, 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 BBB and below investment grade rated classes to portfolios.

^* 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.

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