Europe’s first secured loan ETF listing sidesteps concerns

Europe’s first exchange-traded fund investing in collateralized loan obligations is due to list tomorrow, five years after regulators appeared to tighten restrictions on new UCITS fully invested in the asset class.

The listing of Fair Oaks AAA CLO ETF (FAAA) comes on the back of increased demand for similar ETFs in the US, where net inflows into CLO ETFs hit a record $8.3 billion in the first seven months of 2024, according to Morningstar data. Directly, more than double from last year and five times more than in 2022.

Assets held by Wall Street’s 10 CLO ETFs rose to $14.8 billion — seven times the $2.1 billion they held at the end of 2022, according to Morningstar.

The basics of CLOs are variable-rate corporate loans, often made to companies backed by private equity, typically with sub-investment-grade BB or B credit ratings.

These loans are then securitized, that is, bundled into debt pools. This allows a CLO manager to divide pools into tranches of varying degrees of risk, which can then be sold to third parties such as banks and asset managers.

However, in 2019, European regulators tightened their enforcement of restrictions on CLO investments by mutual funds, according to industry participants.

Most US CLOs have been deemed non-compliant with UCITS due to failure to comply with the so-called risk retention rules.

Separately, the maximum exposure to European and U.S. CLOs deemed compliant has also been unofficially capped, industry figures say.

“The default value was 10%, but national regulators can increase. Some (funds) have been allowed to go up to 25-35%, but that’s it,” said Michael John Lytle, chief executive of London-based Tabula Investment Management, whose parent company Janus Henderson manages the two biggest US CLO ETFs. with combined assets of $12.8 billion.

Since 2020, no new European CLO mutual funds have emerged.

“(CLOs) have been considered by the CBI (the Central Bank of Ireland, the country’s funds industry regulator) and Luxembourg as assets that require higher scrutiny when included in UCI funds. It was felt that there were challenges in terms of liquidity and potential credit exposures,” Lytle said.

Pre-existing mutual funds were, however, allowed to continue operating with 100% exposure to CLOs under a “push-down” clause.

This allowed the Fair Oaks ETF to circumvent the restrictions by being an ETF share class of a €161 million Luxembourg-domiciled actively managed mutual fund launched in 2019.

According to S&P Global Ratings, it will buy only the most senior AAA-rated tranches, none of which have defaulted since it was introduced in 1997.

“Our core belief is that the CLO market generates consistent, repeatable and superior risk-adjusted returns over multiple market cycles relative to other credit strategies,” said Miguel Ramos Fuentenebro, co-founder and partner at Fair Oaks Capital, which manages $3 billion in assets. .

“We have seen increasing interest from investors in the US and we believe this will be the case in Europe as well.”

Roger Coyle, also a co-founder and partner at Fair Oaks, agreed that there is a “perception of complexity” around CLOs and that “regulators are wary of approving CLO investments in vehicles that are typically more retail oriented’, even if in Fair Oaks Where not targeting the ‘mass retail’ market.

However, Coyle argued that CLOs, which are listed but traded “over the counter,” are “very liquid” and very unlikely to default.

“You have to model highly unrealistic scenarios where the entire corporate loan market defaults (for a AAA CLO default),” Coyle said.

Lytle believed there were “misperceptions” about CLOs, in part because of the “three-letter acronym,” a reference to them being associated with collateralized debt obligations, or CDOs, which were central to the global financial crisis because of their credit holdings subprime mortgage. , which CLOs do not own.

“CDOs have been involved in the GFC since 2008, but (CLOs) are very different things. Their structure is quite different,” Lytle said.

“It would take an 80% default rate to trigger a default” in a AAA-rated CLO. “I don’t think people who know anything about structure are concerned with default values,” Lytle added.

Instead, he believed that regulators were more concerned that less sophisticated investors might not understand why CLO funds sometimes suffer trading losses because they might be more comfortable with simpler assets such as the actions.

“It’s a belt and braces concern. If you looked at the situation, you would come to the conclusion that there is no problem,” added Lytle, who said the European CLO market is now around $250 billion, a quarter the size of the US.

The Fair Oaks ETF is described as a Euribor +1.3% product. The mutual fund returned 1.7% in 2020, Coyle said, 0.5% in 2021, lost 2% in 2022 as spreads widened, rose 6.8% in 2023, as spreads narrowed again and returned 5% in the first seven. months of 2024, all in euros.

As for the wisdom of buying floating-rate debt at a time when interest rates are falling, Ramos said “we’re not trying to time the market” and that the expectation of lower rates “is already set.”

Kenneth Lamont, senior fund analyst for passive strategies at Morningstar, said “complicated markets require a lot more due diligence” from investors.

However, he welcomed the launch. “This is what ETFs do well. They represent this force for the democratization of finance. This is just another step on the ladder and I think it should be applauded,” Lamont said. “It’s positive, there’s more choice – access to different asset classes.”

The ETF is scheduled to list on Deutsche Börse’s Xetra exchange on Wednesday and on the London Stock Exchange “shortly thereafter,” with a total expense ratio of 0.35 percent.