CLOs Prove Resilient As Rate Cuts Begin

The VanEck CLO ETF (CLOI) maintained its conservative positioning amid rich valuations and a tightening basis between higher and lower rated tranches. Duration trades paid off in the quarter, however, the final weeks of September illustrated the benefit of having a floating rate exposure given the highly uncertain path of rates going forward. CLOs continued to provide positive total returns despite the commencement of the current rate cutting cycle due to the still high base rates and very strong technicals. However, with expensive valuations and a bifurcated fundamental picture going forward, robust bottom-up security selection will be central to uncovering the best opportunities until any bouts of market weakness favor a shift lower in the capital stack. CLOI performed in line with its benchmark over the quarter.

Market Update

CLOs generated positive total returns across the capital stack in September, the 18th consecutive month of positive returns at the overall index level and the 11th consecutive month of positive returns for all ratings tiers. Carry continues to drive returns given high base rates. The US labor market continued to moderate during the month, with the August payroll report coming up short of forecasts as nonfarm payrolls increased by 142k compared to the median forecast of 165k and bringing the three-month average to the lowest level since mid-2020. Meanwhile, US inflation continued to move closer to target, with the August CPI coming in at 2.5%. The weakening labor market alongside moderating inflation opened the door for the Fed to deliver an outsized 50 basis point (bps) rate cut with a shift in focus to maintaining ‘maximum employment’. The larger-than-expected cut highlights the FOMC’s confidence that inflation will return to target given some of the labor market weakness.

Treasury rates were volatile during September, but decreased overall during the quarter.

Accordingly, floating rate CLOs and bank loans generated positive total returns but underperformed more duration-sensitive investment grade credit and high yield bonds.

Source: JP Morgan and ICE Data Indices as of 9/30/2024. 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.

CLO new issue supply decreased month-over-month following a busier than typical August, with $12.6bn pricing during the month, compared to $14.6bn in August. New issuance volume is now 69% higher than year-to-date 2023. CLO issuance has become more attractive as the arbitrage improved with lower liability costs, leading to the second fastest pace of BSL CLO primary issuance to start a year on record.

Refinancing and reset activity for the year is now $204.8bn compared to just $9.9bn year-to-date 2023. Year-to-date total issuance of $345.7bn is now 270% higher than the same period last year.

In the secondary market, TRACE supply increased month-over-month to $14.6bn from $14.1bn. Investment grade volumes decreased to $9.8bn from $10.8bn, while below investment grade volumes increased to $4.8bn from $3.3bn the prior month. Meanwhile total BWIC volume increased to $5.3bn and was the highest monthly volume since January.

Gross institutional loan issuance accelerated after the dearth of issuance in August, with $69.4bn pricing, after just $7.3bn priced in August. While opportunistic transactions including refinancings accounted for the lion’s share of issuance again this month, there was a notable increase in dividend recapitalizations as well as a rise in M&A and LBO activity. Opportunistic issuance rebounded from the August lows but remained below the average volume set in the first half of the year due in part to the smaller pool of loans trading above par. However, both repricing and refinancing volumes remain at a record pace year-to-date.

The trailing twelve-month default rate within the Morningstar US Leveraged Loan Index was roughly unchanged month-over-month at 0.80%. In contrast, as measured by JP Morgan, the default rate including distressed exchanges is 3.70%. Activity has been elevated as borrowers with unsustainable capital structures endeavored to manage their liabilities and avoid the bankruptcy process through liability management exercises, keeping the “official” default rate lower than otherwise. We anticipate the default rate to remain below historical averages in the near term for the leveraged loan market as a result. None-the-less, our expectations are 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, although with a more positive bias overall. US CLO spreads were tighter across most of the capital stack.

Average Annual Total Returns^* (%) Quarter End as of 09/30/24

^* 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.

CLOI’s gross expense ratio is 0.40% and the total expense ratio is 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 and concerns over a weakening labor market, higher interest rates have yet to drive a material deterioration in credit metrics within the loan market, except for the weakest borrowers. 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, 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. However, following more recent economic reports showing a softening labor market and moderating inflation, the Fed initiated the next rate-cutting cycle with a 50 bps cut in September. Market expectations with respect to Fed easing have moved lower than the most optimistic case in late September, but two more rate cuts are still priced in for 2024. Cuts will provide relief for more stressed borrowers.

CLO prices remain elevated following the significant rally this year with the average AAA-BBB price ending September above par and the basis between higher and lower rated tranches also tight. Against this backdrop, we have paused any broad risk on shifts lower in the capital stack. 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, with secondary AAA-A spreads ending September at or near the tightest levels since 1Q 2022. However, buying in the primary market continues to allow for wider spreads on a relative basis, even when taking spread duration into account.

CLOI Total Return and Credit Allocation

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

Outlook

We’re likely transitioning from a period of high growth to either a soft landing or a typical recession. From a top-down perspective, we see moderating inflation trending toward a soft landing and, alongside a softening labor market, is allowing central banks space to normalize policy. With the commencement of the Fed’s easing cycle with an outsized 50bps cut, any economic deceleration should be cushioned by monetary policy becoming less restrictive in the year ahead. However, the pace of monetary policy changes remains highly uncertain following a blowout nonfarm payrolls report for September, which showed an increase of 254k compared to the median forecast of 150k. In addition, while there is significant uncertainty from the upcoming US elections, the expectations for on-going fiscal spending irrespective of the outcome should provide economic stimulus. There are likely to be certain industries and geographic regional impacts rather than broader recession concerns. Furthermore, geo-political risks appear to be elevated with the conflict in the Middle East escalating. From a fundamental credit profile perspective, the outlook is favorable despite a weakening trend with many metrics starting from high levels. We see no reason to change our default outlook, which calls for a modest increase but not a spike in default activity.

Despite limited net loan issuance, CLO new issuance has continued at a near record pace as managers take advantage of tighter liability spreads. We expect this will continue in the near term given current AAA spreads remain near the tights 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, despite the commencement of the Fed’s rate cutting cycle. In addition to the traditional investor base of insurers, banks, and money managers (among others) – which have been a consistent source of demand given CLOs’ strong performance since the Covid period – the CLO market has also benefited from the growing presence of CLO exchange-traded funds. 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.

Amid the supportive technical environment, 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 twelve months. Notwithstanding the shorter-term technical tailwinds, we believe expensive valuations and a fundamental picture bifurcated between vintages and, relatedly, between deals in and out of their reinvestment periods, calls for a robust bottom-up approach to security selection for long-term investors. Given the dispersion seen in the loan market, certain CLO portfolios holding weaker credits may eventually experience impairments to the lowest rated debt tranches, although some of the weakest borrowers may start to see some relief given rate cuts from the Fed. As a result, vintage, portfolio, and manager selection remains 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.

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