CLO ETFs Face First Big Test as Fed Cuts Interest Rates

CLO exchange traded funds, or ETFs, have been one of the most notable success stories within leveraged finance of 2024. Assets held within these funds recently surpassed $15 billion after posting strong inflows throughout the year, and new entrants to the space continue to emerge. The latest of these is Palmer Square Capital Management, which announced the launch of two credit ETFs, including the Palmer Square CLO Senior Debt ETF (PSQA) on Sep. 11.

These funds are currently facing their first major test as to whether investor appetite will persist even as the interest rate environment changes. After the Federal Reserve cut interest rates by 50 bps on Wednesday, Sep. 18, the first such cut in over four years, some in the market are concerned that retail capital may be poised to rotate into fixed-rate products and away from floating-rate CLO funds.

Others are concerned that the growth of CLO ETFs could lead to an increase in volatility in the CLO tranche market. Although banks have accounted for much of the growth in demand for CLO triple-A paper seen in 2024, with various new banks entering the market and others maintaining their books amid increased paydowns, several sources have told Reorg that ETFs have been the incremental buyer of triple-As with firms tracking inflows to these funds and negotiating tighter spreads when flows were particularly large. Some in the market are concerned that widening could occur at a faster clip if the ETF market sees outflows in the months ahead.

Janus Henderson Investors is the market leader in the CLO ETF space with two CLO-specific funds: the senior debt-focused JAAA with $12.2 billion assets under management, and the $1.03 billion junior-debt focused JBBB. John Kerschner, head of US securitized products at the firm, says that the interest rate outlook at the time the fund launched in October 2020 drew initial investors to the product.

“We launched the fund right as the Fed was thinking about starting to raise rates, which a lot of people were concerned about,” Kerschner said. “It offered a solution that didn’t really exist in the market: people wanted something that was high quality, floating rate and offering a good yield”.

JAAA’s outperformance during the down-market of 2022 caught investors’ attention, well before market technicals of higher-for-longer rates and tightening CLO triple-A spreads aligned for JAAA to add over $7 billion AUM year-to-date in 2024.

“2022 shocked a lot of people. Bond funds were down 10 to 15%, equity funds were down close to 20%” Kerschner says. “Nothing did well except for things like JAAA, which was positive”.

If trading today is any indication, investors have reacted positively to the Fed announcement. Shares of JAAA have spiked from 50.78 cents per share on Wednesday to 50.8 cents per share on Thursday, Sep. 19.
 
Source: Morningstar

Numerous other CLO ETFs have launched in the wake of JAAA, including from firms such as BlackRock, Invesco, Panagram, PGIM and PineBridge. And the numbers continue to grow: in addition to the new funds from Palmer Square, VettaFi reported this week that Virtus, BondBloxx and Nuveen have filed to launch new CLO ETFs, known as Virtus Seix AAA Private Credit CLO ETF, BondBloxx Private Credit CLO ETF and Nuveen CLO ETF.

In Europe, several firms were vying to launch the first CLO ETF while navigating a complicated regulatory environment where few CLO funds were approved in either Ireland or Luxembourg. Many European funds are based in one or both countries and would require approval from their respective regulatory bodies to launch a CLO ETF. Earlier this month, Fair Oaks Capital became the first firm to successfully list a CLO ETF on the continent after grandfathering a share class of its existing UCITS fund Fair Oaks AAA Fund, which began trading as Fair Oaks AAA CLO ETF on Deutsche Börse Xetra on Sep. 11.

Miguel Ramos Fuentenebro, co-founder and partner at Fair Oaks Capital, said that he was pleased his firm was the first to launch a CLO ETF in Europe and said that initial trading had taken place with a tight bid-offer spread.

“We have received meaningful and diverse enquiries from investors following our press releases, and it’s clear there are investors who may not look at funds but are interested in ETFs” Ramos Fuentenebro said. “We have heard about certain investors lacking a mandate to buy UCITS funds, but who find an ETF traded on an exchange to be a compelling alternative.”

Fair Oaks is currently offering market education on CLOs to potential investors in the fund, which trades under the ticker LAAA in Frankfurt and will trade under FAAA in the forthcoming London listing, who may not be familiar with the CLO asset class. Ramos Fuentenebro says that the ETF could mirror the growth pattern of JAAA in the US, especially given that Fair Oaks was the first in Europe to receive regulatory approval and its initial fund-level AUM is around €150 million.

“CLOs represent a large market, and the performance of the asset class is strong, but generally not well known,” he said. “Whether growth will initially be slower and then pick up like with JAAA, or whether investors are now more familiar with ETFs, leading to faster acceleration, is difficult to guess”.

Janus Henderson and Fair Oaks contend that their funds are well positioned to see continued inflows despite falling interest rates. Both told Reorg that the long end of the yield curve has already rallied ahead of the FOMC meeting as the market anticipates rate cuts, and that the CLO ETFs offer a compelling yield pickup compared to treasuries in any case.

“I’m a big believer that the market is discounting lower rates” says Fair Oaks’ Ramos Fuentenebro. “There is a tradeoff between fixed and floating rate exposure that is fairly valued today”.

They also say that the $15 billion footprint of the ETF market is a minor component of the $800 billion market for CLO triple-As and that volatility from outflows will be dampened by continued demand from US and Japanese banks, among other institutional investors.

However others in the market, especially fund managers that do not run ETFs, say that the existence of these funds could add volatility to the tranche market. One managing director at a New York firm with a large portfolio of CLO tranche investments says that, while a small part of the investor base, ETFs, would become the marginal seller if outflows persist.

“They sell indiscriminately because they’re daily liquidity funds and they have to raise money, and that has downstream effects on new issue,” the source said. “The yields were in the high 6s, and are now in the low 6s, which is definitely rates related to some extent. At some point the attractiveness of the ETFs becomes diluted as we see rates come down”.

Nevertheless the yield on a CLO ETF remains around 300 bps higher than a five-year treasury and around 100 bps higher than an investment grade corporate bond fund. Janus Henderson’s Kerschner believes that a large part of the potential investor base for CLO ETFs remains untapped which would see further inflows into JAAA as rates come down.

“There’s a huge trove of $6 trillion cash in money market funds that could still come into the CLO market,” Kerschner says. “These people want to take a little step along the risk spectrum but not into something very risky like equities, just something with a little more yield but still super safe. I think we will see more money come into JAAA from those types of people”.