The latest in a recent trend, PGIM, the investment management business of Prudential Financial, launched an actively managed exchange-traded fund (ETF) July 26 that invests in CLO bonds. PGIM has requested the National Association of Insurance Commissioners (NAIC) to provide a rating for the ETF that is commensurate with the ETF's underlying assets—in PGIM's case almost exclusively CLO 'AAA's—in an effort to slash insurer investors' risk-based capital (RBC) requirement.
"It's a critical component of our expected demand and it's something we're pursuing aggressively," said Matt Collins head of ETFs at PGIM. He added that his team sees significant demand from insurers for the actively managed, floating-rate product, and its 19 basis-point expense ratio is typical for passive ETFs and attractive to fee-conscious clients.
CLOs and CLO ETFs are especially attractive today because of the double tailwind of high short-term rates and wide spreads, resulting in a 'AAA' coupon of 6.8% on the J.P. Morgan CLO index. PGIM expects the ETF product to remain attractive even when short-term rates fall, because it anticipates the long-term average 'AAA' CLO spread remaining at 175 bps over three-month SOFR, significantly richer than other 'AAA' investments.
The NAIC's look-through approach to rating ETFs according to their underlying assets, which it has already applied to numerous other ETFs, is important for insurers because ETFs otherwise must be treated as equity in terms of risk-based capital (RBC). That results in an RBC charge of 1,250%, which translates into risk-weighted assets (RWA) of 100%. Insurers investing directly in CLO 'AAA's would instead face RWA of 20%.
"The risks of a 'AAA' CLO ETF are not that of stocks, so it should be a lower capital charge," said Edwin Wilches, co-head of securitized products at PGIM, adding it would provide rate-sensitive insurers with a floating-rate diversification option.
PGIM holds a 15-year track record investing in CLOs and manages more than $55 billion in CLO assets. Its ETF is aimed at retail investors and has attracted institutional interest, Collins said. By the end of July, the ETF was ramped to close to $105 million and comprised 50 unique bonds across 34 CLO managers.
Currently 100% invested in 'AAA' CLO bonds, the intent is to keep the ETF a "pure play," Wilches said, in part to satisfy investor expectations for a 'AAA' CLO ETF. In addition, 'AA' CLOs pay just 50 bps more than 'AAA' CLOs, so if 10% of the CLO ETF is devoted to 'AA' CLO bonds, the yield difference is only 5 bps.
"For example, we don't think the difference between paying 7.00% and 7.05% justifies the potential volatility of having non-'AAA's in a fund," he said, adding, "we have the flexibility to add non-'AAA's to produce good returns for clients, but we don't see the risk/reward benefit today."
In addition, Wilches said, because ETFs trade throughout the day, consistently maintaining 'AAA' CLOs in the ETF should provide market makers with greater certainty about the ETF's market activity, translating into better executions and tighter bid/ask spreads over time.
AXS Investments launched the first CLO ETF in September 2020, and it is 96.59% invested in 'AAA' CLOs with the remainder in cash and a gross expense ratio of 25 basis points. The VanEck CLO ETF launched in June 2022 invests in investment-grade CLOs and carries a net expense ratio of 40 basis points. Several other investment managers have also launched 'AAA' CLO ETFs over the last year or so, including BlackRock, Invesco, Janus Henderson and Panagram Structured Asset Management, and their percentages of non-'AAA' CLO investments permitted in the fund and expense ratios vary.
Panagram launched its 'AAA' CLO ETF a week before PGIM's and seven months after launching its first CLO ETF that invests in CLO tranches rated 'BBB' and 'BB'. The 'AAA' product carries an expense ratio of 20 bps, and according to John Kim, CEO and CIO at Panagram, the firm intends to limit investments to 'AAA' CLOs.
Over the last 18 months, CLOs have faced a paucity of newly originated leveraged loans to purchase for their portfolios. Nevertheless, new CLOs are continuing to launch, if at slower pace than last year, purchasing more loans in the secondary market.
"We continue to see a pretty robust pipeline [of new CLOs]," Wilches said, adding that other sources of loans include outflows from bank loan funds, liquidations of older CLOs, and separately managed account (SMA) managers selling CLOs as they rotate into other products.
