First ETF for CLOs Is Ultra-Safe. No, Seriously

The snarky comments about financial engineering practically write themselves: An exchange-traded fund investing in collateralized loan obligations? What could go wrong?

In a headline that was guaranteed to grab traders’ attention, Bloomberg News’s Katherine Greifeld wrote on Wednesday that the “First ETF Tracking the $700 Billion CLO-Market Starts Trading.” CLOs have always been something of a bogeyman on Wall Street because of their association with collateralized debt obligations and the seemingly nefarious alchemy of taking pools of speculative-grade loans and turning them into securities with pristine ratings. A widely read article from June in The Atlantic, titled “The Looming Bank Collapse,” cast the $710 billion CLO market as the main culprit that could bring about another financial crisis. My rebuttal to that thesis is here.

Still, the fear over CLOs persists, even among the most knowledgable market veterans. GTS Mischler Principal Reggie Browne, nicknamed the “Godfather of ETFs,” told Greifeld last month that he was worried about individual investors piling into funds tracking CLOs. “Pros, they’ll get it right. My concern is mom-and-pop retail. Education may not be as high for certain retail investors,” he said.

As if to head off this concern, the AAF First Priority CLO Bond ETF trades under an unmistakable ticker: AAA.

It’s a clever marketing strategy by Alternative Access Funds for its ETF debut, but it’s also accurate. The fund “will invest in U.S. dollar-denominated first priority CLOs that are rated AAA or equivalent by various nationally recognized statistical ratings organizations,” according to a release. The top tranches have famously never defaulted, even during the worst of the 2008 financial crisis, because they’re structured in such a way that American companies would have to close on a huge scale to even begin to inflict losses. According to analysis from Moody’s Investors Service, the cumulative collateral default rate would have to reach 70% to 80% before double-A CLOs would be impaired, assuming a 60% recovery rate. The triple-A tranche is even further out of reach.