Shifting Fundamentals Call for CLO Selectivity

The collateralized loan obligation (CLO) market has experienced a significant rally since late 2022, with prices soaring and spreads tightening to levels not seen since early 2022. The increasing demand for CLO paper, fueled by the expansion of CLO ETFs and strategic reallocations by major investors like Japan's Norinchukin Bank, has driven spreads tighter, particularly at the AAA level. This has also led to elevated valuations, with most CLO tranches trading above fair value. As a result, the spread basis between ratings and manager tiers has compressed, making it more difficult for investors to achieve alpha. Despite these challenges, the demand for CLOs is expected to remain strong, supported by both traditional investors and the burgeoning CLO ETF market.

However, the market is starting to exhibit signs of weaker fundamentals, with a noticeable increase in deals exposed to lower-rated Caa/CCC holdings. This trend underscores the importance of a bottom-up approach, which involves a detailed analysis of the underlying CLO portfolios to mitigate risks associated with the rising CCC exposure. A robust selection process can help identify opportunities and generate superior investment outcomes, especially in a market where technical tailwinds may persist in the short term but where fundamental risks are becoming more pronounced.

In the article, After the CLO Rally, Selectivity Will Be Key as Fundamentals Shift, PineBridge Investments explores in-depth the uptick in market activity and the importance of a more selective, bottom-up approach in navigating the risks and opportunities in CLOs.

Key Takeaways

• Strong Demand for CLOs: Demand for collateralized loan obligations (CLOs) has been robust, driven by the growth of CLO ETFs, reallocations by large investors, and sustained interest from traditional CLO investors.
• Rising Prices and Tightening Spreads: The average price of AAA to BBB-rated CLOs is now above par, approaching five-year highs, with a decline in the spread basis between rating tiers, making it more challenging to generate alpha.
• Emerging Weaker Fundamentals: Signs of weaker fundamentals are emerging, with increasing Caa/CCC exposure, necessitating a bottom-up approach for better investment outcomes.
• Selectivity is Crucial: Given the current market dynamics, a selective approach focusing on the underlying CLO portfolio holdings is essential to navigate risks and enhance potential returns.

Ultimately, we believe a more selective, bottom-up approach will result in stronger risk-adjusted returns and outperformance potential over the broader market and peers in the long run.

Investing in CLOs with VanEck

The VanEck CLO ETF (CLOI), subadvised by PineBridge, may offer an attractive way for investors to efficiently access the CLO 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). Drawing on decades of CLO experience, through PineBridge’s active management, CLOI 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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