Since the first collateralized loan obligation (CLO) exchange traded fund (ETF) launched in late 2020, strong investor demand has driven rapid growth in both the size and the number of CLO ETFs. These funds have injected new liquidity into CLO primary and secondary markets and granted retail investors access to securities previously available only to institutional buyers. In this commentary, S&P Global Ratings examines what's fueling the rise of the CLO ETF sector, its portfolio compositions and purchasing activities, as well as the extent to which these ETFs could impact CLO tranche pricing under certain economic conditions.

The CLO ETF Landscape

Assets under management (AUM) among all U.S. CLO ETFs has risen to over $19 billion as of fourth-quarter 2024 from just $120 million in fourth-quarter 2020. Janus Henderson Investors (Janus), the second firm to launch such an ETF, is the top player in the space by a wide margin, with its JAAA and JBBB offerings representing about 76% and 6% of total U.S. CLO ETF AUM, respectively. Several large asset managers have followed Janus's lead, with BlackRock, Invesco, and PGIM releasing CLO ETFs of their own to address the growing investor appetite. Some new market entrants have also enjoyed strong growth in AUM. The portfolio of PGIM's 'AAA' CLO ETF (PAAA) increased more than two-fold from September 2024 to late November 2024--nearly matching the $1.26 billion valuation of JBBB's portfolio--and the list of newcomers continues to expand. Nuveen, Virtus Investment Partners, and BondBloxx are planning to enter the CLO ETF market, according to recent filings with the Securities and Exchange Commission (SEC). To date, most CLO ETFs have invested in 'AAA' rated CLO notes backed by U.S. broadly syndicated loans (BSL). However, Fair Oaks Capital debuted the first European CLO ETF in early September 2024, and a handful of forthcoming funds will focus on acquiring U.S. middle-market (MM) CLO tranches. Table 1 lists CLO ETFs currently on the market, as well as those that are soon to launch.

This commentary will focus on the first 10 CLO ETFs in table 1. Among other characteristics, table 1 shows the recent 30-day SEC yields for most of the ETFs we consider. The yields tend to cluster around two distinct levels, depending on whether a fund focuses on 'AAA' or lower-rated CLO tranches. However, there is variability within rating classes, some of which could be explained by the discrepancies in dates at which the latest yields for individual funds were determined. Therefore, different results could be obtained depending on whether the yield is calculated before or after an intra-month movement of the secured overnight financing rate (SOFR), which is the typical index of the floating-rate CLO notes.

Table 1

The Meteoric Rise Of AUM

CLO ETFs emerged in the fall of 2020 when short-term interest rates were near their effective floors and CLO tranche credit spreads were at historically high levels. Because CLO notes are predominately floating-rate securities, ETFs such as JAAA proved to be a lucrative investment when the Fed carried out its last monetary tightening cycle between 2022 and 2023--especially given the underlying CLO notes' attractive spreads and resilient, recession-tested credit histories (see "Thirty Years Strong: U.S. CLO Tranche Defaults From 1994 Through Third-Quarter 2024," published Sept. 27, 2024).

Chart 1 below shows that at the end of fourth-quarter 2021, JAAA's AUM stood near $370 million. Only one quarter later (shortly after the Fed's first rate-hike of the last tightening cycle), its AUM had surged to about $1.2 billion. In 2024 alone, total CLO ETF AUM has grown by more than $13 billion; however, most of this growth is attributable to JAAA, which is sufficiently large to purchase CLO notes in the primary market, and in some instances, act as an anchor buyer. If the rapid pace of growth in the space continues, it's possible that several of the smaller CLO ETFs could build up sufficient capital to place primary market anchor orders and negotiate tranche spreads to SOFR.

Chart 1

Key factors: monetary policy and refinancings/resets

Chart 1 also shows the trajectory of 90-day average SOFR, which coincides with the growth of the ETFs. However, just as the run-up in interest rates motivated heavy CLO ETF inflows, a monetary easing cycle could have the opposite effect. If a succession of interest rate cuts lowers CLO ETF dividends to a level deemed unacceptable to a critical threshold of investors, their repositioning into equities or fixed-rate debt could lead to net outflows. The Fed cut its policy rate by 50 basis points (bps) and 25 bps in September and November, respectively. However, according to S&P Global Ratings chief U.S. economist, "The fed funds rate outlook will likely rise as the Fed focuses on keeping inflation expectations anchored. Higher short-rate expectations and term premium (amid higher inflation and interest rate uncertainty) mean a higher benchmark 10-year Treasury yield than previously expected over the next year" (see "After Trump's Win, What's Next For The U.S. Economy?" published Nov. 7, 2024). If investors believe the resurgence of high inflation is a reasonably likely outcome due to re-inflationary U.S. federal policy or other influences, strong inflows into CLO ETFs could persist.

Another key factor that can affect the magnitude of the periodic CLO note payout, and in turn the size of a CLO ETF dividend, is the extent to which the CLO notes held by the ETFs are refinanced or reset (refi/reset). 2024 has eclipsed 2021 as the record year for refi/reset issuance. This year's monthly refi/reset volume has outpaced that of 2021 since April, and many CLO notes with historically wide spreads (mostly from the 2022 and 2023 vintages) have been repriced at much lower spreads. If CLO note spreads continue to tighten, 2025 could be another banner year for refi/reset issuance, especially considering the increasing incentive of the large 2021 CLO vintage. The "moneyness" of a CLO tranche is determined by the difference between note spreads (to SOFR) and prevailing market spreads. While we regularly monitor this market feature (see "Will Market Volatility Reset CLO Reset/Refi Volume Expectations For Second-Half 2024?" published Aug. 14, 2024) as it pertains to refi/reset issuance expectations, it could have implications for CLO ETF demand inasmuch as continued refi/reset momentum might lead to a reduction in dividends.

Are ETFs Big Players In The CLO Market?

The U.S. CLO market is roughly $1 trillion, with annual new issuance year-to-date of over $180 billion. Most of these securities are owned by institutional investors, including banks and insurance companies, many of which buy and hold for the long term. ETFs own a relatively small portion of the total outstanding amount (under 2% of par balance); however, this figure is expected to grow. Despite being a minor player in the broader CLO space, ETFs occasionally make substantial purchases in the primary market. For example, we have identified about 20 instances when JAAA bought at least $100 million (par value) of a CLO's 'AAA' rated class A-1 notes, which we think constitutes an anchor order. Although such large purchases are the exception rather than the rule (even for JAAA), ETFs have been active CLO buyers over the past four years.

Based on the timing and the size of the CLO acquisitions in their portfolios, we believe that most (but not all) of the purchases by ETFs in table 1 were secondary market acquisitions. Because JAAA is such a large fund, however, it can more easily participate in primary market offerings. We estimate that at least a quarter of JAAA's initial purchases of unique CLO tranches were settled in the primary market. While most of the purchases were substantially smaller than the $100 million anchor orders discussed above, JAAA purchased roughly 26% of par value (on average) of tranches we assessed as having been acquired in the primary market. Despite being part of the Janus family, JBBB is not as big a player in the primary market--presumably because there is less subordinated CLO paper available.

The average initial par balance of tranches owned outright (i.e., 100% of par) by JAAA is $15.5 million, almost all of which we estimate to have been primary market purchases. In many cases, JAAA purchases the entire primary offering of the 'AAA' rated A-2 tranche, which is subordinate to the much larger 'AAA' rated A-1 tranche. The A-2 piece typically has a longer weighted average life (WAL) and a spread pickup (on the order of 20 bps) relative to the A-1 class, which we believe is more a reflection of spread duration and liquidity risk than credit risk. Most tranches owned entirely by JAAA are A-2 notes, and these positions are spread across transactions maintained by over 40 distinct CLO managers.

Chart 2 below breaks down the ETFs' ownership shares in the CLO tranches that they currently hold.

Chart 2

Most of the ownership is under 10% of the outstanding tranche balance. However, it is not uncommon for ETFs to own between 10% and 30% of a tranche, especially if they are buying in the primary market (typically JAAA, but to some extent other funds, such as the Panagram ETFs). Chart 2 also shows that for greater ownership shares (more than 30%), Janus (particularly JAAA) dominates the other ETFs.

The Composition Of The Funds

It's likely that CLO ETFs have focused on BSL CLOs in part because they make up a larger segment of the CLO space, presenting a wider selection of credits in both the primary and secondary markets. We expect two MM CLO-focused ETFs to become available soon. However, it remains to be seen if they grow at the same pace as their BSL counterparts given the lower annual volumes in the MM sector. It is possible that these funds will exist as hybrids, containing both BSL and MM CLOs, such as Invesco's ICLO, which is a fund backed predominantly by BSL CLOs, but with some MM CLO tranches in its portfolio. In any case, 2024 has seen strong issuance in the MM space, so there should be ample collateral for the forthcoming Virtus and BondBloxx ETFs.

There are differences between MM and BSL CLOs that may affect the nature of the ETFs that hold them. The most important distinction concerns market size. BSL CLOs are the older segment and make up roughly 90% of the outstanding CLO universe. Issuance of MM CLOs (which comprise loans from the direct lending market to smaller, riskier companies) started to accelerate in 2017 but has grown considerably since then. Under normal market conditions, MM 'AAA' CLO tranches exhibit liquidity that is comparable to that of 'AAA' BSL CLO tranches; however, the fact that the MM CLO market is significantly smaller suggests that it could become less liquid than that of BSL CLOs under certain economic conditions. While this feature might constrain the eventual size of the MM CLO ETF market, we note that MM CLO credit has exhibited a strong track-record. Another important difference concerns the spreads. In part a reflection of liquidity risk, MM CLO spreads tend to be wider than those of BSL CLOs, which could be a selling point for ETFs. As of October 2024, however, the spread differential between MM and BSL 'AAA' CLO tranches has tightened to only 25 bps compared to an average of 70 bps a year earlier.

The 10 ETFs under consideration in this article hold CLOs with characteristics that are broadly consistent with those of our rated portfolio of BSL CLO transactions, although there is some variation by ETF. The S&P Global Ratings-rated reinvesting CLO notes held by the ETFs have average 'CCC' exposure, default exposure, and junior overcollateralization levels that are in line with the broader universe of CLO tranches we rate, suggesting the ETFs are picking a well-diversified collection of credits.

Spreads of CLO tranches in ETFs are in line with market averages, but there can be variability and skewness

Chart 3 below shows the spreads of individual CLO tranches within each ETF relative to weighted average BSL CLO market spreads within a given rating category (we compare the spread of each CLO note to the weighted average spread of all BSL CLO notes of the same rating category priced in the same month).

Chart 3

Spreads generally cluster about the average; however, there are some interesting observations. In the case of JAAA, there is a clear bimodality, which we believe reflects the acquisition of both A-1 and A-2 tranches, with the latter having greater spreads for reasons described above. There are a handful of lower-rated credits within JAAA ('A' and 'AA' notes), some of which we believe were purchased in conjunction with 'AAA' notes from the same CLO transactions. Finally, CLOZ and JBBB appear to skew negative. CLOs often have two tiers of 'BBB' rated tranches, with the senior 'BBB' class offered at a lower spread. Because the reference average for the rating category incorporates both classes, the spreads of tranches held by CLOZ and JBBB will be relatively tight if the funds are systematically purchasing the senior of the 'BBB' rated tranches. The spreads on tranches held by JBBB and CLOZ could also skew tighter than the market average if these funds tend to purchase notes from refinanced CLOs, which deleverage faster than newly issued and reset transactions.

Mechanics Allow An ETF's Share Price To Deviate From Net Asset Value

Unlike open-ended mutual funds, which are obligated to sell assets when they do not have ample cash reserves to meet redemption requests from investors, ETFs are not forced to sell portfolio assets when secondary market investors sell off the ETF's shares. In this way, an ETF's share price can deviate from net asset value (NAV) per share, especially in times of market volatility, whereas an open-ended mutual fund's shares will re-price to the NAV at the end of each trading day. Much of the time, disparities between an ETF's share price and its underlying portfolio value will be corrected by the ETF manager's mark-to-market portfolio valuation and secondary market investors' opportunistic trading of the ETF shares. Under certain circumstances, however, the trading activities of authorized participants (APs)--large financial institutions that are permitted to create and redeem ETF shares at the end of each trading day--drive NAV per share and the ETF's share price toward parity.

APs are the only investors that can exchange blocks of ETF shares (i.e., redemption units) for predetermined quantities of securities and/or cash within the ETF's portfolio (and vice versa). For example, if an ETF is trading at a discount to NAV, an arbitrage opportunity presents itself, and APs are incentivized to buy the ETF's shares in the secondary market and redeem them at the end of the trading day for a basket of the ETF's portfolio holdings. In the case of JAAA, a creation unit consists of 50,000 shares, and a redemption unit consists of 200,000 shares (valued at about $2.54 million and $10.17 million, respectively, based on the Nov. 19, 2024, closing share price). While share redemptions across all the ETFs have probably occurred only seldom, given the growth of CLO ETF demand, share creations have certainly taken place in force. The portfolios of JAAA and JBBB have primarily grown via two processes: (i) an AP assembles a group of CLO notes they deem desirable for JAAA or JBBB, which Janus is free to approve, adjust, or decline; or (ii) Janus's internal trade desk directly solicits CLO managers/arrangers to negotiate the size and price of CLO positions they want to acquire.

The fact that open-ended mutual funds are forced sellers can be problematic for investors because it means that assets are sometimes sold at a discount to a fundamental value. Moreover, because the mutual fund manager will try to avoid selling assets at a steep discount, the "best" assets are typically selected for sale, leaving the less liquid and often risker assets to make up a larger share of the fund. This means that there is an incentive for mutual fund investors to be the first to get their money out in a downturn (i.e., run-on-the-bank behavior). ETFs, on the other hand, are ordinarily free to refrain from rectifying the price/NAV mismatch directly. It is worth noting that when an unusually wide gap between an ETF's share price and its NAV per share lingers for a prolonged period, it is possible for the ETF to be delisted by the exchange on which it trades, although this is an uncommon scenario, characteristic of severely stressful economic conditions.

Could ETF Activity Impact the Broader CLO Market?

Since the inception of CLO ETFs in 2020, there has been very little outflow, as evidenced by the growth trajectories shown in chart 1. Apart from the second quarter of 2021, total AUM increased during each quarter since the market kicked off in 2020. In the case of Janus's funds, the only instance of AP share redemptions for underlying CLO tranches was during the unwind of the Yen carry trade after the Bank of Japan's August 2024 rate hike. Otherwise, Janus's ETF shares have only ever been created. This speaks to the steady growth and upward price momentum of the CLO ETF sector, considering Janus ETFs make up over 80% of the current market.

How ETFs can influence CLO tranche pricing

Some market participants believe steady demand from ETFs will reduce CLO tranche spread volatility--especially among mezzanine tranches--and growing demand from ETFs has probably helped drive some of the CLO spread tightening we've seen this year. During periods when traditional CLO primary market buyers (e.g., U.S. bank treasury departments, Japanese banks, and U.S. insurance companies) disengage, CLO ETFs could make up for their (temporary) market absences and provide issuers with greater opportunities to place notes and execute their issuance pipelines. In addition, ETFs could influence primary market pricing to some extent if they are acting as anchor buyers, and they may provide secondary market buyers and sellers of CLO notes with a stable source of liquidity, facilitating improved transparent price discovery and higher routine trade volume.

However, the CLO ETF sector remains untested in a significant economic downturn, and these funds have yet to endure a bout of heavy outflows. Uncertain paths of future interest rates have many industry players speculating whether CLO ETFs might soon face their first test. If the Fed continues cutting interest rates, the allure of CLO ETFs could fade such that some investors sell their holdings and look elsewhere to invest. This would likely result in downward price pressure for the ETFs, and potentially, a greater imbalance between ETF share prices and portfolio values. Regardless of whether outflows are motivated by falling interest rates, credit issues, or other factors, CLO ETFs are unlikely to be a primary driver of CLO note price declines, owing to the ETF mechanics (discussed below) and the ETFs' currently small ownership share of the CLO universe.

The APs that can facilitate the trueing-up of NAV per share and ETF share price may be unable to capture any existing arbitrage opportunities precisely because the market for the underlying securities (CLOs in this case) is substantially less liquid than large cap equities or treasuries, for example. (Although CLOs are liquid relative to many structured finance asset classes, it may not be cost-effective to take short positions.) If investors rapidly sold off the shares of a CLO ETF due to perceived weakness in the CLO market, APs might refrain from purchasing and redeeming ETF shares because they are uncertain of the price at which they can sell the CLO notes in the redemption basket. This would reduce sales volume and provide market participants more time to re-value CLO tranches as conditions stabilize. Alternatively, it is reasonable to consider that the APs might not intend to sell the CLO notes in the redemption basket immediately (or whatsoever). APs are well hedged and strongly capitalized financial institutions, and they might choose to hold the CLO notes in the redemption basket until market conditions stabilize, or simply maintain the CLO positions over a longer time horizon. In this sense, ETFs discourage "bank run" type behavior because of the structural disconnect between "panic selling" in the secondary market and actual portfolio sales.

We are not suggesting that ETFs could stabilize a distressed market. Rather, we think that they would not exacerbate volatile CLO market conditions because there is an inherent decoupling between ETF investor share sales and CLO sales from the ETF's portfolio. Nevertheless, it is reasonable to believe that even if there are no forced CLO sales, the lack of purchase activity on the part of ETFs during a period of market stress or falling rates could lead to CLO spread widening as demand falls in the primary and secondary markets.

Possibility for CLO ETF market to freeze

In what is perhaps the worst-case scenario, it is possible that either the market for CLO ETFs or CLO notes themselves (or both) could freeze in the sense that buyers and sellers can't agree upon transaction prices. While the AP could step in and, for example, purchase "cheap" ETF shares and deliver them to the ETF in exchange for "rich" CLO notes, it is under no obligation to do so. This suggests there are situations in which a NAV/ETF price mismatch could persist if the market for ETF shares becomes illiquid. This risk is described in ETF filing documents. In the case of JAAA, for example, they warn of "Authorized Participant Risk" whereby "APs have no obligation to submit creation or redemption orders and, as a result, there is no assurance that an active trading market for the Fund's shares will be established or maintained." They go on to state that, "…to the extent that those APs exit the business or are unable to process creation and/or redemption orders, and no other AP is able to step forward to create and redeem in either of these cases, shares may trade like closed-end fund shares at a premium or a discount to NAV and possibly face delisting."

Should an ETF be delisted, it is possible that the fund would be a forced seller, which could result in bulk sales of CLO notes into what is presumably already a volatile and stressed market. It is important to consider that the APs are usually large banks with broad portfolios, and they might be positioned to ride out temporary volatility in CLO prices. Therefore, in situations for which the market for CLO ETFs becomes thinly traded, the APs might be incentivized to acquire discounted CLO notes from the fund in exchange for shares (i.e., redemption units) that the AP acquired at a discounted but not unreasonably low price in the open market.

Outflows and using CLO ETF portfolio overlap to gauge pricing impact

All markets are cyclical, and CLO ETFs will at some point experience a period of outflows that could lead to sales of underlying CLO note positions. It is therefore meaningful to determine the extent to which CLO ETFs overlap in terms of their holdings. One standard way to compare two or more funds is to order all like holdings and add together the smaller of the two portfolio weights. In this way, if fund A doesn't own CLO tranche X, and fund B has 1% exposure to CLO tranche X, there is no contribution to overlap. If CLO tranche Y is 1% of fund A and 2% of fund B, 1% is added to the total overlap. The sum, which can lie between 0% and 100%, gives a measure of the extent to which two or more funds own the same CLO notes in the same proportions.

Table 2 provides the pairwise overlaps between the 10 ETFs under examination. Interestingly, the overlaps are all relatively low, with the greatest overlap between CLOX and CLOA at roughly 11%. This is positive for the sector because it means that if APs for multiple funds decide to redeem shares for collateral simultaneously, it is unlikely that they will be acquiring the same basket of CLO notes, which should help minimize the strain on the CLO market (and the prices of individual CLO tranches) when the APs sell. It is important to note that table 2 is not weighted by dollar amount. This means that even though the overlap between JAAA and other ETFs is low, the impact on the market of a large JAAA outflow would be greater than for other funds because of its size.

Table 2

Abundant Investor Demand For CLO ETFs, But Risks Remain

We have seen rapid growth of the CLO ETF sector over the past four years, so there is clearly abundant investor demand for the product. Presumably much of the demand is driven by investors' desire for attractive dividends that grew out of an elevated interest rate environment. However, the product may continue to grow even as rates moderate or fall, in which case we expect CLO ETFs to contribute positively to liquidity and pricing in the underlying CLO market, particularly for the 'AAA' rated A-1 and A-2 tranches. While we do expect periods of outflows at some point, due either to interest rate or spread movements, or to economic volatility in general, it is unlikely that ETF outflows will lead to any substantial downward pressure on CLO tranche prices. This is because, under normal market conditions, most sell orders will be matched with investor buy orders. Meanwhile, the APs stand ready to address situations in which there is a deviation between the NAV per share and the ETF share price.

This is not to say the sector is without risks. A severe market dislocation could lead to ETF liquidity problems that the AP is unwilling or unable to correct. In the unlikely scenario that an ETF is delisted, and assets are liquidated, the marginal increase in downward price pressure on an already strained CLO market is not expected to be material given the current size of the ETFs. Should the CLO ETF market continue to grow at its current pace, however, the potential for a meaningful impact on CLO pricing could materialize--positive or negative--and APs' creation and redemption activities might exert greater influence on broader CLO pricing.