2023-10-10 08:36:20 ET
Summary
- The Janus Henderson BBB CLO ETF provides exposure to floating-rate CLO tranches rated from B to BBB.
- CLOs have historically had better credit performance than similarly rated corporate bonds, but with rising interest rates and increasing corporate bankruptcies, their credit performance may be at risk.
- The JBBB ETF can be thought of as a leveraged play on senior bank loans - BKLN. Depending on your forward views on credit, JBBB can be attractive or unattractive.
I have written quite a bit on Collateralized Loan Obligation ("CLO") funds in the past few months, and this article reviews the Janus Henderson B-BBB CLO ETF (JBBB).
The JBBB ETF can be thought of as a leveraged way to play the bank loan (leveraged loan) asset class. Given expectations of elevated corporate defaults in the next two years, I recommend investors stay in safer, senior investments.
Fund Overview
The Janus Henderson BBB CLO ETF provides investors with exposure to floating-rate CLO tranches rated from B to BBB in a liquid and transparent investment vehicle. Historically, debt tranches of CLOs have been the domain of institutional investors like pension funds and insurance companies. However, in the past few years, we have seen a few ETF launches in this space with the aim of distributing these formerly institutional products to retail investors.
The JBBB ETF was launched on January 11, 2022 and so far, has only been able to gather $118 million in assets (Figure 1). The JBBB ETF charges a 0.50% net expense ratio.
Figure 1 - JBBB overview (janushenderson.com)
CLOs Have Been Around For Decades
While retail investors may not be familiar with Collateralized Loan Obligations , the investment product has been around since the late 1990s. A CLO is a collection of leveraged loans that have been packaged, securitized, and split into debt tranches with varying degrees of risk (Figure 2). The securitization and tranching process allows highly rated securities to be synthetically created from underlying leveraged loans that may not be investment grade-rated themselves.
Figure 2 - CLO overview (janushenderson.com)
Structural enhancements such as overcollateralization and interest diversion help protect CLO debt securityholders (AAA to BB in Figure 1 above) from losses. Illustratively, overcollateralization means that $100 worth of leveraged loans are used to create $90 worth of rated debt securities. If defaults were to occur in the underlying loans, the Equity tranche will bear the brunt of these defaults. Only when the Equity tranche has been wiped out will lower rated junior debt tranches start to suffer defaults and so on and so forth. Senior CLO tranches also have priority over the cashflows from the underlying leveraged loans.
The creation of the CLO asset class have dramatically increased the universe of highly rated debt securities that risk-adverse institutional investors like pension funds and insurers can buy, while risk-seeking hedge funds and CLO Equity funds like Oxford Lane Capital ( OXLC ) hoover up the equity and junior debt tranches due to their attractive yields.
CLOs Pay A Yield Premium...
Compared to similarly rated corporate bonds, the main benefit of CLOs is that CLO debt tranches are able to offer a yield premium (Figure 3). In an era of zero interest rates, any incremental yield pick-up was greatly desired by investors.
Figure 3 - CLOs offer a yield premium compared to corporate bonds (janushenderson.com)
...And Hardly Any Have Defaulted
At the same time, historical data suggest CLO debt securities may have better credit performance than similarly rated corporate bonds. In fact, according to data from Standard & Poor's, CLO 1.0s (those issued before the Great Financial Crisis) have produced very few lifetime defaults, with 0 defaults out of 1,540 AAA-rated tranches, and only 38 defaults out of 4,322 total rated tranches, or 0.9% (Figure 4).
Figure 4 - CLO credit performance through time (guggenheiminvestments.com)
Since 2008, additional structural enhancements have been made to the CLO structure to protect senior securityholders, and the result have been even better credit performance so far.
Investors Should Be Wary Of The 'Sure Thing'
However, as with all things related to Wall Street, investors should be wary of any 'sure thing' investments. Due to their impressive credit performance through the Great Financial Crisis 'trial by fire', investors have had an insatiable appetite for CLOs and their underlying leveraged loans, helping the asset class grow to almost $800 billion in CLOs outstanding by Q2/2021 (Figure 5).
Figure 5 - US CLOs outstanding (pinebridge.com)
While credit performance has been strong to date, that mainly reflects the prior decade's rock-bottom interest rates where companies can seemingly refinance and borrow money for 'free'.
However, since the Federal Reserve has been aggressively raising interest rates in the past 2 years to combat inflation, corporate bankruptcies have begun to climb, with Standard & Poor's reporting 459 corporate bankruptcy filings in the year-to-date August 2023, more than the full year figure in 2021 and 2022 (Figure 6).
Figure 6 - Corporate bankruptcies are starting to rise (Standard & Poor's)
In fact, Fitch Ratings forecast leveraged loan default rates will hit 4.0%-4.5% in 2023 (Figure 7), up significantly from the sub-2% default rate in the past few years and close to the crisis levels seen in 2020 (Figure 8). So it remains to be seen whether CLOs will continue to show unblemished credit performance when their underlying leveraged loans start to default left and right.
Figure 7 - Fitch predicts leveraged loan defaults will soar in 2023 (Fitch Ratings)
Figure 8 - Historical leveraged loan default rates (morningstar.com)
Portfolio Composition As Expected...
Returning to our review of the JBBB ETF, we can see from Figure 9 that JBBB's portfolio currently holds 67 securities with a portfolio yield to worst of 9.7%.
11.3% of JBBB's portfolio is currently A-rated and 86.9% is BBB-rated (Figure 10).
Figure 10 - JBBB credit quality allocation (janushenderson.com)
...Paying An Attractive Distribution...
The JBBB ETF pays an attractive monthly distribution, with a trailing 12 month distribution of $3.69 or 7.8% yield (Figure 11).
Figure 15 - JBBB pays a 7.8% distribution yield (Seeking Alpha)
...But Total Returns Have Been Mixed
Since inception, the JBBB ETF has delivered mixed returns, with a solid 10.5% return YTD August 2023, but only 2.8% average annual return since inception, implying 2022 was a down year (Figure 12).
Figure 12 - JBBB historical performance has been mixed (janushenderson.com)
Historical Returns Leveraged To Underlying
In fact, going through JBBB's annual report, we can see that the JBBB ETF suffered a sharp 9.9% decline in the fiscal year from January 11, 2022 to October 31, 2022, underperforming the JPMorgan CLO High Quality Mezzanine Index's -8.2% decline (Figure 13).
Figure 13 - JBBB suffered a 9.9% loss in fiscal 2022 (JBBB annual report)
What is interesting with JBBB's fiscal 2022 returns is that the Morningstar LSTA US Leveraged Loan 100 Index ("LSTA Index"), a passive index measuring the performance of leveraged loans, the underlying building blocks of CLOs, only suffered a 3.1% decline in this time period, from 2,429.76 on January 11, 2022 to 2,354.34 on October 31, 2022 (Figure 14).
Figure 14 - Leveraged loan asset class only suffered a small 3.1% loss from January to October 2022 (spglobal.com)
So true to design, the junior debt tranches making up JBBB's portfolio suffered leveraged losses relative to the underlying loans in order to protect the value of the senior tranches. This is confirmed by analyzing returns of the Janus Henderson AAA CLO ETF ( JAAA ), which invests in AAA-rated CLO securities.
JAAA recorded a much small 1.5% decline in the fiscal year ended October 31, 2022, less than the 2.4% decline of the LSTA Index, as measured from 2,412.10 on October 31, 2021 to 2,354.34 on October 31, 2022 (Figure 15).
Figure 15 - JAAA performed much better in 2022 due to its seniority in CLO structure (JAAA annual report)
This leveraged effect is more pronounced if we plot the daily returns of the JBBB ETF against the JAAA ETF and the Invesco Senior Loan ETF ( BKLN ), a passive ETF tracking the LSTA Index (Figure 16). From JBBB's inception to September 30, 2022, when the BKLN ETF bottomed, the BKLN ETF lost 6.3% while JBB lost 10.6% and JAAA lost 1.5%.
Figure 16 - JBBB vs. BKLN and JAAA, January 11, 2022 to September 30, 2022 (Seeking Alpha)
Since September 30, 2022, the BKLN ETF has rallied 12.8% while JBBB has rallied 17.7% and JAAA rallied 8.3% (Figure 17).
Figure 17 - JBBB vs. BKLN and JAAA, September 30, 2022 to October 6, 2023 (Seeking Alpha)
The JBBB ETF appears to have ~1.5x leverage to BKLN returns, with downside leverage of 1.7x (10.6%/6.3%) vs. upside leverage of 1.4x (17.7%/12.8%).
JBBB Investment Rating Dependent On Credit Outlook
I am personally cautious on the outlook for the leveraged loan asset class, as I believe we are starting to see the delayed impact of the Federal Reserve's rate increases flow through the economy. Referring to Figure 7 above, a 7.5-9.0% cumulative default rate on leveraged loans in 2023-2024 may be a headwind for the LSTA Index in the coming quarters.
At the very least, LSTA Index forward returns should be lower than historical average annual returns of 5.3% over 5 years or 3.9% over 10 years (Figure 18).
Figure 18 - Historical average returns of LSTA index (spglobal.com)
If the LSTA index actually suffers declines in the coming months, then I expect the declines to be magnified for JBBB due to the subordinated nature of its holdings, similar to the declines shown in Figure 13 and 16 above.
Risk To Cautious View
Of course, if my outlook for credit performance on leveraged loans prove too conservative and the leveraged loan asset class delivers strong forward returns, then the upside for JBBB is magnified as well.
However, given tightening financial conditions from the Federal Reserve's 'higher for longer' monetary policies, I prefer to err on the side of caution and avoid potential steep losses.
Conclusion
The JBBB ETF is a novel ETF offering retail investors access to junior debt tranches of CLO securities. The JBBB ETF can be thought of as a leveraged way to play the leveraged loan asset class, given the subordinated nature of its holdings.
I believe forward returns for the JBBB ETF may be poor given expectations of elevated credit defaults in the coming quarters. Choosing between JAAA's 6.1% yield and senior holdings versus JBBB's 7.8% yield and subordinated holdings, I believe JAAA is preferable given where we are in the credit cycle. I rate JBBB a hold .
For further details see:
JBBB: Leveraged Play On Bank Loans