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Anticipated Interest Rate Boosts
Inflationary concerns prompted the Federal Reserve (“Fed”) to end their bond-buying program in late 2021. At its March 16th 2022 meeting, the Fed raised interest rates by 0.2% for the first three years. The current rate for inflation in the United States is 8.0%.1After years of low interest rates, the market expected the Fed would raise rates. This month’s rate rise met those expectations.
The market is anticipating multiple rate increases and, indeed, Fed Chairman Jerome Powell on March 16 hinted at six additional increases over the remainder of the year to combat inflation. It is possible that we could see a cumulative interest-rate increase of 1.50% in 2022.2This paper examines access to CLOs during rising interest rates and how they can be an attractive alternative to other credit types.
Fed Funds Overnight rate to rise at upcoming Central Bank Meetings
Source: Bloomberg
Note: Prices effective 3/9/2022 Cumulative Rate Increases Expected refers to the number cumulative hikes (+/-) or cuts (-), as estimated by the associated meeting. This is calculated by dividing the implied rate increase by the assumed rate change. The implied interest rate is the overnight rate that is expected to be charged after the corresponding Central Bank meeting. It is implied by the instrument. On 03/16/2022, the last meeting was displayed. Future meetings will be shown between 05/04/2022 and 02/01/2023.
CLOs and Investment Access
XA Investments LLC (“XAI”) believes floating-rate loans as well as collateralized loan obligations are attractive investment options in today’s rising rates environment. The XAI Octagon Floating Income Term Trust (“XFLT”) or the “Trust” is a closed-end fund that is listed.3It invests in a portfolio that includes floating-rate loans, CLO and equity. The Trust’s portfolio as of December 31, 2020 was invested in CLO equity and debt (50%), first lien and 2nd lien loans (46%), as well as other investments (4%). CLO investing presents new opportunities and risks to investors. XAI believes that the Trust may be able to benefit from its investments in floating-rate securities, with an average effective duration of less six months. Active management may also be beneficial to the Trust during a rising rate period.
An array of mutual funds and ETFs have provided exposure to floating-rate loan risks for a long time. Closed-end funds are also available. Advisors and investors are familiar with the risks and benefits of loans. CLOs, on the other hand, are more complicated to access and less familiar. Investors may find floating rate coupons in the CLO marketplace attractive, with interest rates set to rise from historic low levels.
CLOs can be a natural hedge against rising interest rates due to their floating rate income and low duration risk.4CLO debt securities with higher coupon rates pay higher interest rates. CLO equity securities offer more nuanced returns. Equity holders often receive a higher “spread” over the long term as interest rates rise. In contrast, interest rates on traditional fixed-income investments are locked or “fixed” and can be adversely affected by rising rates.
The Response of CLOs to Changes in Interest Rates
CLO debt tranches generally offer higher yields than similar rated corporate bonds and other structured products. They can also offer capital preservation potential through structural protections or investor-centric covenants. The CLO structure has been proven to be resilient in all market cycles. There has never been a documented default in the AAA or AA CLO debt tranches.5Diversification benefits can also be realized through negative correlations to U.S. Treasury bond and low correlations with investment grade corporate credit and equity. CLOs also offer access to a wider range of debt issuers than high yield bond markets, which is a benefit.
The collateral manager buys a portfolio floating-rate loans (typically 150 to 300 issuers) using proceeds from the CLO debt or CLO equity issuance. The coupon interest on CLO debt securities is paid with the interest earned from floating rate loans. After interest payments have been made and operating expenses paid by the CLO, any residual cash flow or remaining cash flow is distributed to CLO equity or “residual” holders. These equity investors are often the first to absorb loan portfolio losses, reducing residuals.
CLOs are attractive for investors who are concerned about rising rates on credit instrument. Investors who anticipate a rate rise may find the floating-rate bank loans purchased by CLO collateral managers attractive. The interest paid on the underlying loans can rise with rising interest rates, which can ultimately benefit the CLO, and in particular the CLO equity owners.
Rate hikes and the Implications from LIBOR/SOFR floors
Most loans on the marketplace have LIBOR floors (or SOFR floors), which is 50 to 75 basis points.4If the loan is already paying the minimum rate or the floor rate, then there could be a delay in the rate rise. Rates must rise to the floors in order for floating-rate investor to see the benefits of rate increases. If the rate market moves above the floors multiple times, then loan interest will change with changes in rates.
The following page contains a table that summarizes the performance for various asset classes over the five Fed tightening cycles. While it can be difficult to predict the future, historical data may help you make a decision. CLO debt and floating-rate loans can outperform fixed income with a longer duration, such as municipal bonds and investment grade bonds.
Fed raises rates and CLO debt outperforms floating-rate loans
|
Performance during past Fed tightening periods |
|||||||
|
Date range |
RateHike(bps) |
U.S. Treasuries |
InvestGrade Credit |
MunicipalBonds |
High Yield |
Floating RateLoans |
CLO Debt (BB rated tranches). |
|
2/4/94 – 2/1/95 |
300 |
-7.65% |
-3.93% |
-3.56% |
-1.74% |
9.33% |
n/a |
|
6/30/99 to 6/16/00 |
175 |
2.99% |
0.10% |
-0.16% |
-2.27% |
3.06% |
n/a |
|
6/30/04-6/29/06 |
425 |
8.59% |
5.85% |
9.30% |
14.88% |
5.92% |
n/a |
|
12/16/15-12/31/18 |
225 |
7.93% |
8.95% |
7.82% |
20.02% |
14.75% |
36.63% |
Source: U.S. Treasuries are represented by Bloomberg US Long Treasury Total Return Index. Investment Grade Credit is represented by Bloomberg US Credit Index. Municipal Bonds are represented by Bloomberg US Municipal Index. High Yield is represented by Bloomberg US HighYeld 1% Issuer Capital Index. Floating rate loans are represented by Credit Suisse Leveraged Loan Index. CLO Debt can be represented by the J.P. Morgan Collateralized Obligation Post Crisis BB Index (“CLOIE”) The indices’ data are available at the end of each month. CLOIE index was created on 12/30/2011.
Benefits of investing in CLOs
Below is a table that summarizes key attributes of CLO securities in comparison to other structured and credit securities. CLO investing is not without risk. There are risks associated with CLO investing, including loss, accounting, valuation, leverage risk, market volatility risk, and risk of losing. For more information on CLO investing, see page 4.
|
Attractive yields |
CLO debt offers the possibility of incremental yield pickup relative to similarly rated bonds or other structured securities6 |
|
Low historical defaults |
CLO debt tranches have shown lower long-term default rates than similarly rated U.S. corporate creditors instruments5 |
|
Income at a floating rate |
Coupon floats that are based on LIBOR or the new market standard SOFR may be a benefit to investors during periods of rising short term interest rates.7 |
|
Portfolio diversification |
CLO debt has low correlations and investment grade corporate credit, but a negative correlation with U.S. Treasury bonds |
|
Inflation hedge |
CLO securities and floating rate loans can be used to hedge against inflation. These floating rate investments show a higher correlation with inflation than other inflation-hedgings like commodities and infrastructure. |
Footnotes
1According to the U.S. Bureau of Labor Statistics Consumer Price Index 12-Month percentage increase for the year ended Jan 2022.
2 Bloomberg.
3Closed-end fund (CEFs), which are actively managed portfolios, are subject to active risk management. CEF shares often trade at a discount relative to their net assets value. A CEF investment is subject to investment risks, including the possibility of losing all your principal investment.
4Senior secured loans are subject to reference rate floors. These floors are typically tied to LIBOR and increasingly SOFR. The LIBOR floor is most often 0.50%. Senior secured loans investors enjoy higher interest payments when LIBOR is above 0.50%. Similar levels can be expected to continue as SOFR is introduced.
51993-2017 Moody’s Investors Services, Inc., Moody’s Analytics, Inc., their licensors, and affiliates-used only with limited permission, Moody’s Investors Services, Special comment: Default & Loss Rates Structured Finance Securities: 1993 – 2017. November 6, 2018. This is the most recent information available from Moody’s.
6J.P. Morgan Credit Strategy Weekly update: High Yield and Leveraged Loan Research February 11, 2022.
7Citi Research, “2022 Global CLO outlook” (December 14, 2022).
Editor’s Note:Seeking Alpha editors selected the summary bullets for this article.