Published in London & New York
10 Queen Street Place, London
1345 Avenue of the Americas, New York
Creditflux is an
company
© Creditflux Ltd 2024. All rights reserved. Available by subscription only.
Opinion CLOs
Triple As could widen rapidly if CLO ETF managers see large outflows
by Thomas Majewski
Thomas Majewski
Founder & managing partner
Eagle Point Credit Management
CLO ETFs are likely to grow rapidly, bringing increased volatility to the CLO market
A long-standing trend across many large asset classes has finally come for CLOs: the “ETFifaction” of the market. Other than a small number of listed closed-end funds principally focused on the lower parts of the CLO capital structure, there have been few ways for retail or institutional investors to get professionally managed exposure to the CLO asset class via a listed investment product. Further, there has been no way to get pure-play access to the senior part of the capital structure via a listed product.
The first CLO ETF was created in 2020, but the segment remained largely overlooked by many investors. However, over the past year, CLO ETFs have grown at a rapid pace as investors that were previously focused on listed markets — both retail and institutional — began to find CLOs an attractive floating-rate, diverse and strong-performing asset class.
While more than USD $10bn of CLO ETFs are outstanding today, they remain a relatively small part of the overall CLO market. However, we think the segment is likely to grow further. And as more investors gain access to the CLO market via ETFs, it is important to consider the potential implications of this trend.
Adapting to new flows of capital
We expect there will be growing pains in the CLO market as it adapts to the likely faster pace of flows into and out from the asset class. Similar to the way in which retail loan fund flows can impact loan prices, CLO ETFs may cause CLO debt liability spreads to tighten during periods of inflows. Material ETF outflows, in turn, could have a pronounced adverse effect on spreads and prices due to forced selling by ETF managers.
We have seen historic periods where similar forced sellers exacerbated market volatility. For example, during periods when CLO triple A repo trades were being unwound in scale, CLO triple As widened as much as 10 to 20 basis points in a very short period of time. Firms trying to price a new CLO at that time likely found themselves in a difficult situation. The same rapid widening could happen if CLO ETF managers are forced to sell in large sizes due to outflows.
The impact of mezzanine CLO ETFs facing the same or similar market forces could be even more extreme. These investments typically have a wider bid-ask spread versus CLO triple As — and less bid depth. This makes efficiently trading mezzanine CLO securities challenging, even during relatively calm market periods. The issues are exacerbated during volatile periods.
If CLO mezzanine ETFs had been common during the first half of 2020, there could have been even more intense selling pressure, echoing the challenges faced in other sectors, such as the loan market. The mismatch between how ETFs trade (electronically and with a tight bid/ask) versus how CLO mezzanine tranches and even CLO triple As trade (over the phone and with a wider bid/ask) may pose a problem for the CLO ETF market.
Benefits of closed end funds
We don’t expect many mezzanine ETFs to be on the offense in future market sell-offs, and they are likely to lock in realised losses. For this reason, we believe the best way to access CLO mezzanine and equity tranches continues to be via closed-end funds. These structures protect investors from being exposed to forced selling of a fund’s portfolio. For example, because they didn’t face outflows, some closed-end funds were able to lock in attractive buys when others were forced sellers in 2020.
To our knowledge, there are five listed closed-end funds in the market focused on CLOs. More are in the registration process, further confirming that closed-end funds are considered by many to be the most attractive way to access the lower part of the CLO capital structure.
While the short-term whims of ETF flows may begin to have sudden impacts on CLO pricing, what is even clearer is that the expansion of these ETFs introduces a new force. We recognise they’re here to stay. As CLO ETFs grow, we hope they help bring liquidity to the CLO market as secondary trading volume increases.
We welcome CLO ETFs for the potential scale they can bring — but we recognise the added short-term volatility that will likely come with it.
