Last month’s decision by the Fed to stand pat is doing more to funnel money into an obscure pocket of the ETF market than any single product launch has.
Todd Rosenbluth, head of research at VettaFi, reckons collateralized loan obligations could be where the exchange-traded fund business pushes next. What’s fuelling appetite for the alternative assets, he said, is the unresolved uncertainty around interest rates.
“[CLOs have] been popular within the marketplace,” Rosenbluth said this week.
So what sits inside one? CLOs are short-term fixed income strategies assembled out of pools of floating-rate secured loans, built to offer relative stability and appealing yields across market cycles.
Waiting on the Fed is itself a strategy
There’s nothing subtle about the appeal. When the central bank’s next step is anybody’s guess, short duration beats long duration and floating rate beats fixed.
“We’ve seen fixed income ETF demand be quite strong,” Rosenbluth said. “I think that’s going to continue as we’re still waiting for some clarity from the next move of the Fed.”
He singled out last month’s decision to leave rates where they were as the trigger for demand for short-term products.
Issuers aren’t waiting around
Flows drag launches along behind them, and the launches are arriving. Rosenbluth pointed to Reckoner Capital Management, an ETF provider that specializes in CLOs, as a firm actively creating new CLO ETFs this year.
“That’s caught our attention,” he said. “It’s just great to see the innovation that’s happening within the fixed income ETF marketplace.”
What advisors are actually doing with them
The behaviour on the ground is tamer than the launch calendar would suggest. These are not core holdings.
Jennifer Grancio, global head of distribution at TCW Group, said the same tilt toward fixed income is visible from an asset manager’s chair.
“I think a lot of advisors are holding a core income-oriented portfolio and then dabbling a little bit with short duration or CLO products,” Grancio said.
Dabbling. That’s the word coming from the distribution side, and it describes the trend more honestly than most of the noise around it.
The part that doesn’t fit on a fact sheet
Rosenbluth makes no pretence that the risk is absent, and the detail counts for more than the category label. CLO tranches do not all behave alike.
“While AAA-rated CLO tranches boast near-zero default rates, lower-tier tranches (BBB-B) face heightened default risk and market volatility during economic stress,” he wrote in a special note.
Then comes the correlation nobody puts in the marketing. “In addition, because corporate loans in CLO pools carry significant exposure to tech and software sectors, private credit jitters or tech selloffs can spill over and trigger spread widening,” Rosenbluth wrote.
Worth a second read if you own tech equity. A CLO ETF pitched as a diversifier away from the stock market can end up sharing a risk factor with the stock market, by way of the loan book.
Where the demand is concentrated
Which is why the buying isn’t spread evenly up and down the credit stack. Investors are reaching for AAA-rated and senior-secured assets, Rosenbluth said, to capture attractive yields without that long-term maturity risk.
That is the whole trade, compressed into a sentence. Take the yield at the top of the structure, skip the duration, and don’t reach down into the BBB-B tranches for a few extra basis points while the Fed’s next move is still unknown.
Anyone shopping this category should look at the tranche rating before the yield printed on the marketing page. A CLO ETF is not a single asset class, and the distance between AAA and B is the distance between near-zero default rates and heightened default risk during economic stress.