The last few years have been difficult for bond investors. At first, interest rates were below historical averages, creating a difficult search for yield. Then the environment changed drastically in 2022 as the Federal Reserve implemented a series of interest rate hikes causing bond prices to fall sharply. Amid this volatility, a growing number of investors have broadened their bond horizons and added floating rate debt securities to their portfolios to increase the diversification of their fixed income holdings.
Unlike most traditional fixed income investments, floating rate securities offer a return that rises and falls with a benchmark interest rate, such as SOFR (Secured Overnight Financing Rate). Because the coupon “floats” above the prevailing interest rate, floating rate bond prices are less sensitive to changes in the prevailing interest rate.
Although floating-rate debt has been around for decades, its availability is limited in the United States, and high-quality (A-rated or better) security choices are even rarer. For many years, investors seeking floating rate exposure have favored the leveraged loan market, but because it is a sub-investment grade market, the benefits variable rate exposure are achieved at the expense of lower credit quality. Given this trade-off and growing economic uncertainty, investors are increasingly turning to another type of variable-rate debt: secured loan obligations (CLOs), as around 80% of CLOs have a credit rating of credit from A to AAA.
For nearly three decades, CLOs were largely only available to institutional investors, however, in 2020 the first ETF CLOs were launched, giving every investor access to the benefits of this asset class. Because of this better accessibility and a yield premium over other corporate credit instruments, the global market for CLOs has grown to over $1 trillion, despite the challenges of having a name that sounds a lot like the Collateralized Debt Securities (CDOs), a financial instrument widely known to have played a leading role in the global financial crisis of 2007-2008.
To be clear, CLOs are not the same as CDOs.
CDOs typically consisted of BBB-rated subprime mortgage securities first created in 2000. As a result, rating agency models for these mortgages were poorly calibrated since mortgages had only been around for a few years, and before the Global Financial Crisis, the U.S. real estate market had not seen a year of nationally negative appreciation since the Great Depression of the 1930s.
As mortgage holders began to default on their loans, including some within 90 days of mortgage origination, mortgage originators began to fail, housing prices soared, and the market of CDOs quickly collapsed.
Unlike CDOs, which were largely made up of consumer debt such as mortgages, car loans and credit cards, CLOs are securitized portfolios of commercial bank loans, which are issued to small businesses that do not generally have no access to bond markets. And rating agency models for corporate credit date back over 100 years, providing much more data for better calibration. Notably, not a single AAA CLO has defaulted since the inception of the asset class 30 years ago, a period that includes the global financial crisis and the economic disruption created by COVID-19. Throughout these extraordinary events, which had a significant impact on financial markets around the world, CLOs behaved as expected.
In fact, the two busiest months for AAA CLO trading were March 2020, a month marked by one of the most dramatic stock market declines in history (the Dow Jones Industrial Average fell about 26% in four trading days), and March 2022, when the Fed announced the long-awaited first interest rate hike, and fixed income assets declined overall. During the two months, the liquidity of many segments of the bond markets was negatively affected, but this was not the case for AAA CLOs. The liquidity of AAA CLOs increased during these months, demonstrating the resilience of the asset class.
In light of this track record, the risk-return profile and low correlation of other fixed income investments, including US Treasuries and the benchmark Bloomberg US Aggregate Bond Index, the recent surge in demand investors for CLOs is perhaps not too surprising. But with the Federal Reserve acting aggressively to reduce inflation by raising the fed funds rate, and most observers anticipating further hikes, many investors are taking a closer look at the performance of CLOs in times of rising rates. .
Prior to 2022, the most recent rate hikes occurred between December 2017 and late November 2018, when the Fed raised interest rates by 1.25%. During this period, the Bloomberg US Aggregate Bond Index lost 1.62%, the shorter duration 1-3 year Bloomberg US Government/Credit Index gained 0.82% and the JP Morgan AAA CLO increased by 2.55%.
Dating back a few more years to the previous tightening cycle, which occurred from December 2015 to November 2018 when the Fed raised rates by 2.25%, the JP Morgan AAA CLO index rose 8.63%, more than three times the yield of the Bloomberg 1-3. year US Government/Credit Index.
While this type of capital appreciation during a period of rising interest rates may seem counterintuitive, such is the nature of floating rate securities. And for those willing to look past the pitfalls of having a name that is often confused with secured debt securities, CLOs can be an attractive means of portfolio diversification in these volatile markets.
John Kerschner is Head of US Securitized Products at Janus Henderson Investors
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