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Why invest in a European credit ETF
Miguel Ramos Fuentenebro
Co-founder and Partner
Summary
ETFs have enabled a broader range of investors to gain access to different asset classes, thereby unlocking new investment opportunities. Credit ETFs offer investors daily liquidity to a previously difficult to access corporate credit market, along with transparency and cost efficiency.
CLO ETFs have become increasingly popular in the US, given the structural benefits and higher return profile of CLOs all within the accessibility and tradability of an ETF wrapper. Fair Oaks brings this asset class and structure to Europe in the form of European CLO ETFs.
In Europe, access to higher yielding floating-rate debt is challenging for investors to obtain. With fixed income yields less attractive in a higher and uncertain rate environment, investors should look for alternative sources of returns to provide diversification to portfolios, without taking additional risks of illiquidity or complex and costly structures. CLOs provide access for investors to gain exposure to floating-rate corporate credit through public markets.
Access to CLOs have largely been reserved for banks, pension funds, insurance companies and other specialist institutional investors. As ETFs promote liquidity, transparency and democratization of assets, the use of this structure to invest in CLOs has opened barriers for new investors. Therefore, a wider audience can benefit from the higher carry, downside protection and diversification of CLOs.
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Efficient trading with daily liquidity
CLO ETFs trade in the primary and secondary markets, creating liquidity across multiple channels. This enables investors to access CLOs in a low cost, transparent and accessible way.
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ETF asset liquidity (CLO market): The large size and liquid nature of the CLO market helps to provide underlying liquidity for the ETFs. The global CLO market stands at $1 trillion and growing, with both large primary market volumes and active secondary market trading. Investors trading CLO ETFs gain direct access to the fund’s actively managed portfolio of CLOs.
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Primary market liquidity: Shares in the primary market are created and redeemed by Authorised Participants. This allows for large flows without unnecessary volatility and allows the ETF share price to track to the NAV of the fund’s CLO assets. The ETF can also trade even without exchange drive secondary market flows as investors can buy and sell directly with Authorised Participants via OTC trades.
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Secondary market liquidity: The ETFs are available on multiple exchanges, such as the London Stock Exchange and Deutsche Borse, enabling a pan-European investor base daily access to CLOs. Investor-to-investor trading of shares occurs on exchanges via brokers with a bid-offer spread set by market makers. This democratises access to a wider investor base and provides investors more control.
European ETFs are often classified as UCITS funds. This is a widely-recognised cross-border framework which promotes standardization of certain procedures, ensures appropriate governance structures and requires minimum portfolio diversification and risk management. This therefore reduces counterparty risk and enables access to a broader investor base.
During the life of a CLO, the vehicle is actively managed until the end of the reinvestment period. This allows the CLO manager to add value through buying and selling loans, position the portfolio in the context of changing market conditions subject to investment guidelines and compliance of tests.
After the end of the reinvestment period, loan principal repayments are used to pay down CLO liabilities, starting from the most senior AAA CLO notes, following the same “waterfall” as interest payments. Often the CLO is called before maturity, meaning the CLO debt is repaid at par, realising any current market discount.
Transparent European credit access
Unlike other fund structures, ETFs enable direct and transparent exposure to the underlying fund holdings, gaining efficient and quick access to the asset class. While US investors can invest in senior secured loans through well-established loan ETFs, European investors have been unable to access the European corporate credit market in the same way.
Historically allocating European corporate credit funds has often meant investors are forced to accept additional risks such as illiquidity or opacity of investment portfolios. A European ETF exposed to CLOs allows investors to access European corporate credit and also benefit from a CLO’s structure as well as the transparency of an ETF. While CLOs are an established market, the asset class has been largely reserved for large institutional investors such banks, pension funds, insurance companies and other specialist investors. A European CLO ETF therefore opens access to this asset class to a broader investor base.
CLO ETFs can be used for strategic allocation – taking a long-term approach to investing in CLOs while benefiting from the transparency of the structure, with full portfolio holdings and daily pricing made widely available. Alternatively, investors can allocate tactically – taking advantage of the daily liquidity and efficiency of the structure to flexibly rebalance portfolios or quickly gain exposure to the asset class.
Active portfolio management
As the CLO market has grown to over $1 trillion globally, portfolios can be actively traded to efficiently generate returns for investors. While CLO market growth has increased liquidity, pricing dispersion has also increased, requiring additional investment due diligence.
Given the mechanism of CLO trading, there is currently no investable CLO index for investors to use to gain access to the market. Instead, CLOs must be actively traded by experienced investment managers specialising in corporate credit and CLOs.
Fair Oaks has deep expertise in this market, having multiple decades of combined experience and a broad coverage of European corporate credit – actively investing in senior secured loans, high-yield bonds and CLO debt notes across the capital structure (from AAA to single-B tranches). Other investors may not be resourced to perform bottom-up analysis to fundamentally value the market to the same degree. Fair Oaks can assess the market for opportunities in primary or secondary markets and tactically allocate by identifying sources of relative value.
An actively managed CLO ETF can provide investors with the confidence to invest in the CLO market alongside large institutional investors, while diversifying their portfolios. By allocating to CLO ETFs, investors can unlock access to alternative credit, offering potential for higher returns than other fixed income assets.
Active portfolio management by CLO manager
As a CLO manager actively trades the portfolio over the lifecycle, CLOs can mitigate risk and take advantage of developing market conditions, despite not being marked-to-market. This enables managers to avoid default risk from any downward credit migration, participate in new transactions as other loans are repaid, and ensure continued compliance with all diversification requirements and coverage tests required by the CLO structure. This means that there are ultimately two investment teams underwriting the portfolio – the CLO manager and the investor in the CLO note.
Traditionally, the CLO market has largely reserved for institutional investors such as banks and pension funds. Given the CLO’s growing market size and efficient trading, open-ended funds investing in CLOs have increased in recent years.
Conclusion
CLOs offer access to senior secured loans while tailoring for varying risk-adjusted return appetites and taking no mark-to-market risk.
Credit losses are mitigated by the presence of credit enhancements (subordination and excess spread), embedded tests (with associated diversion protocols) and active management.
CLOs are an established and liquid market with a 25+ year track record and is a market more than $1+ trillion in size.
CLOs can provide a valuable addition to a diversified fixed income portfolio given their attractive risk-adjusted return and floating-rate nature.
Endnotes
- Fitch’s,” U.S. Leveraged Finance Restructuring Series: Ultimate Recovery Rate Study (First-Lien Term Loan Recoveries Dip in 2020, Begin to Recover in 2021)”, 21-Mar-22.
- S&P’s, “Default, Transition, and Recovery: 2022 Annual Global Leveraged Loan CLO Default And Rating Transition Study”, 10-year time horizon, 13-May-23.
- Bank of America and Pitchbook LCD. Average par subordination of European CLO tranches between 2013 and 2022. For illustrative purposes only.
- JP Morgan as at 29-Feb-24. Euro CLOIE, European AAA-BBB Corporates, European Leveraged Loan Index, European HY Index.
- S&P’s, “Default, Transition, and Recovery: 2022 Annual Global Leveraged Loan CLO Default And Rating Transition Study”, 10-year time horizon, 13-May-23. S&P’s “Default, Transition, and Recovery: 2022 Annual Global Corporate Default And Rating Transition Study”, 10-year time horizon, 25-Apr-23.
