It's good to be the first ETF in a new asset class.
The first asset manager to launch actively managed ETFs investing in collateralized loan obligations (CLOS) has captured more than six times the assets under management (AUM) of its six rivals put together. However, those rivals foresee room for all in a much larger CLO ETF market that could at least in part replace banks as critical investors in CLOs' highest rated bonds.
Janus Henderson Investors launched its AAA CLO ETF (JAAA) in October 2020 with sizable initial assets under management (AUM) of $120 million, and by February of this year it grew to $6.7 billion. Its BBB CLO ETF (JBBB), launched in January 2022 with $25 million, invests in CLOs rated from B to BBB and climbed to $207.2 million. John Kerschner, head of U.S. securitized products at Janus, said he anticipates the JAAA fund continuing its current growth rate of $1 billion every two months, potentially adding another $5 billion by year-end.
"We would expect the overall CLO ETF market to eventually grow to somewhere in the range of $20 billion to $30 billion," Kerschner said, adding, "The AAA CLO ETF market will probably be 80% of the overall CLO ETF market as it matures."
If those estimates comes to pass, the Janus CLO ETFs could end up with half of all CLO ETF assets under management. It's competing, however, against major asset managers including BlackRock, PGIM and Invesco for that distinction. They cater to a deep and broad base of investors. CLO ETFs total less than $10 billion today, not quite 1% of the total CLO market. Those managers see that share growing significantly since only qualified institutional buyers managing at least $100 million of securities can invest directly in CLOs, and the ETF wrapper opens the asset class to a much wider range of investors.
"A big part of the appeal of an ETF wrapper is that it now provides investors with an exposure that would have been pretty hard for them to access before," said Steve Laipply, Global Co-Head of iShares Fixed Income ETF at BlackRock.
Retail investors, for example, purchased upwards of 90% of both Janus funds, for example, often via their registered investment advisers (RIAs), according to Janus.
Main street appeal
Edwin Wilches, co-head of securitized products at PGIM, said that PGIM's CLO ETF (PAAA) has seen significant investment directly by retail investors and by institutions purchasing the bonds on their behalf, including RIAs, private banks and pension funds. Although the first ones emerged four years ago, half the CLO ETFs launched in 2023, and most investors are probably still unfamiliar with the floating-rate product that provides a premium over comparably rated bonds and diversifies portfolios.
Laipply said new ETFs typically attract home offices, RIAs and other wealth investors until they reach a size that appeals more to institutional investors. He said that insurance companies that are already familiar with BlackRock's CLO platform are "extremely" interested in the BlackRock AAA CLO ETF (CLOA).
"The idea of an ETF is very attractive to them for cash flow management, because it allows them to navigate liquidity without having to buy and sell the underlying assets," he said.
This may be the new marginal buyer that comes into the market.
Wilches said that in 2021, banks increased their CLO investments to $177 billion from $108 billion, and CLO ETFs could see a similar leap, resulting in their marginal share of the CLO market today growing to a more meaningful size, perhaps in the $50 billion to $100 billion range.
"Maybe CLO ETFs get big enough to where they help replace some of the U.S. money center banks' lack of appetite for AAA CLOs," Wilches said. "This may be the new marginal buyer that comes into the market."
It may take a while, though. John Kim, CEO and CIO at Panagram, noted that banks typically invest $25 million to $300 million in AAA CLOs, far more than today's CLO ETFs can do.
One hurdle, he added, is that it is hard for CLO ETFs to buy primary deals, because their long settlement periods result in the missed yields reflected in their net asset values (NAVs).
The AAA CLO ETFs' documentation typically allows up to 20% of their investments in AA- or A-rated CLOs, providing a safety valve in the case of downgrades. A few, like the Panagram AAA CLO ETF (CLOX) and the PAAA seek to minimize holdings below AAA, to minimize risk and maintain a top rating for insurance-company investors, while others may dip down opportunistically.
The second largest CLO ETF as of Feb. 23, with $268 million AUM, was the Van Eck CLO ETF (CLOI). It charges 40 bps, subadvisor PineBridge Investments has more flexibility to invest further down the capital stack, including up to 20% in BB-rated bonds.
"We haven't added any BB-rated notes to the portfolio, and we don't see doing that unless there's a massive dislocation" and the bond is significantly mispriced, said Komal Shahzad, vice president at PineBridge.
JAAA charges 22 bps, a few basis points above AAA competitors, including PAAA, CLOX, and CLOA. Invesco AAA CLO ETF (ICLO) launched in December 2022 charging 26 basis points, but since the start of 2023 it has waived the fee, recently extending the waiver until April.
"We don't necessarily see the ETF as a retail product but rather driven by institutional demand," said Ian Gilbertson, co-head of U.S. CLOs at Invesco, adding that the ETF's $57.5 AUM as of February 23 includes paying back the $30 million in seed capital.
The higher yielding BBB ETFs offered by Janus and Panagram (PBBB) charge fees in the 50 basis-point range and have grown substantially, with JBBB reaching $207.2 million on February 23, from $25 million at inception in January 2022, and PBBB increasing to $212.2 million from $50 million when launched in January 2023.
'A' grade relative values
Shahzad said that CLOI is currently 85% invested in AAA, AA, and single A CLOs, with approximately half that in AAA bonds—a bit less than previously—and the rest in BBB. She noted that the AAA and AA bonds have strong bank and insurer buyer bases, and in the current market demand for AAAs and AAs is strong compared to mezzanine tranches.
"Therefore, we are finding better relative value opportunities in mezzanine tranches, rated single A and BBB," she said.
CLO ETF asset managers' outlooks for the CLO market were mixed. CLO spreads have tightened this year, prompting a flood of refinancings and resets, but whether that continues is up in the air. The tight arbitrage between CLO assets and liabilities last year, a headwind for CLO equity investors and issuers, has improved by a few percentage points to around 8%, absent a refinancing.
"It's still not where it should be. We think the arbitrage is still very challenged and we're not seeing a lot of attractive new-issue deals," Kim said.
Wilches noted factors that could limit further spread tightening, including a strong pipeline increasing deal supply and a return of AAA-investing banks that may be less robust than touted.
"We're seeing regional banks selling CLOS in the secondary market," he said. "It's not untrue that large banks are buying, but I don't think they're net adding. It wouldn't surprise me if the $202.9 billion that was reported on U.S. banks' balance sheets at the end of 2023 slips by around $10 billion at the end of this year."
