Why CLOs Still Make Sense When the Fed Cuts Rates

One of the most common questions we receive from investors is: Why would we invest in collateralized loan obligations (CLOs), which pay floating rate coupons, if the Federal Reserve is cutting interest rates?

Our answer is simple: diversification, protection against volatility, higher credit spreads, and lower risk support the case for a strategic allocation to CLOs through market cycles. In addition, changing market environments can provide compelling opportunities for actively managed CLO strategies that can take advantage of higher yields.

Fundamentally, building a diversified portfolio that does not take outsized duration or credit bets can help to achieve better outcomes through market cycles, and we believe including credit-sensitive floating rate instruments like CLOs should be part of that. CLOs have outperformed Treasuries, investment grade corporates, and the broad U.S. aggregate market over the past decade, and outperformed high yield corporates and leveraged loans on a risk-adjusted basis. Their higher yield and low default risk, as well as floating rate nature, have driven this performance through varying market environments.

Since the current rate cutting cycle began in September, long term yields have increased and CLOs have outperformed investment grade bonds, high yield bonds and the aggregate U.S. market (which have experienced negative returns), as of [10/31/2024]. This is just another example of the benefits of diversification and insulating a portfolio against market volatility.

CLOs Have Outperformed Since First Rate Cut (9/18/2024 – 10/31/2024)

Source: J.P. Morgan and ICE Data Indices as of 10/31/2024. CLOs represented by J.P. Morgan CLO Index; HY Corporates represented by ICE BofA US High Yield Index; IG Corporates represented by ICE BofA US Corporate Index; US Broad IG Market represented by ICE BofA US Broad Market Index. Past performance is no guarantee of future results. Index performance is not representative of fund performance. It is not possible to invest directly in an index.

When evaluating CLOs in a rate cutting environment, it’s important to note that because coupons adjust with prevailing short-term rates, CLO prices are not materially impacted by rate declines. Another key point: because CLOs are securitized pools of leveraged loans, returns are largely driven by credit exposure, and that provides unique opportunities when market conditions change – for example when the economy enters a new rate cycle. The spreads achievable on CLOs, particularly within mezzanine tranches, is indicative of this significant credit element. For example, in the case of BB CLOs, the coupon spread above the 3-month Secured Overnight Funding Rate (“SOFR”) is greater than SOFR itself.

CLO Coupons Well Above SOFR

Source: J.P. Morgan and Bloomberg, as of 10/31/2024.

Historically, credit spreads tend to be negatively correlated with the direction of interest rates. For example, high yield bond spreads and 3-monthT-bill returns have exhibited a correlation of -12% since 12/31/2003, and the relationship is -38% compared to the 10-year U.S. Treasury bond.¹ When rates are declining, this means investors can capture higher spreads, particularly in lower rated tranches, allowing for the potential to both participate in upside price recovery and capture high absolute yields. To benefit from this dynamic, however, the ability to dynamically allocate to higher or lower quality tranches is necessary.

For example, during the last rate cutting cycle that began July 2019, which was driven by slowing economic growth, spreads widened. Through the third rate cut in that rate cutting cycle (in October), CLOs generally underperformed duration sensitive credit sectors, as longer-term yields declined modestly. However, by the end of January 2020, after three rate cuts, different CLO tranches exhibited very different performance, as shown below.

BBB and BB CLOs Outperformed U.S. High Yield Bonds and Leveraged Loans as the Fed Cut Rates

Returns shown are cumulative over the indicated date ranges. Source:. VanEck, Morningstar and JP Morgan 8/31/2024: Morningstar. Broad CLOs represented by J.P. Morgan CLO Index, AAA Rated CLOs represented by J.P. Morgan CLO AAA Index, AA Rated CLOs represented by J.P. Morgan CLO AA Index, A Rated CLOs represented by J.P. Morgan CLO A Index, BBB Rated CLOs represented by J.P. Morgan CLO BBB Index, BB Rated CLOs represented by J.P. Morgan CLO BB Index, US IG represented by ICE BofA US Corporate Index, US HY represented by ICE BofA US High Yield Index, Leveraged Loans represented by Morningstar LSTA US Leveraged Loan 100 Index, ST Corp IG represented by ICE BofA 1-5 Year US Corporate Index and ST HY represented by ICE BofA 0-5 Year US High Yield Constrained Index. Past performance is no guarantee of future results. Index performance is not representative of fund performance. It is not possible to invest directly in an index.

U.S. investment grade corporates, with the longest duration among these asset classes, performed the best, driven by the decline in longer term bond yields. However, BBB and BB CLOs outperformed U.S. high yield bonds (both the broad market and 0-5 year high yield bonds) and leveraged loans. AAA rated tranches, the least credit and rate sensitive segments represented, underperformed while AA and A rated CLOs performed approximately in line with leveraged loans and short-term U.S. investment grade corporate bonds. We note that the Fed cut rates further in February 2020, which was due to the onset of COVID, so less relevant for this analysis.

While looking at a discrete time period can be helpful, we believe from a strategic portfolio perspective, looking at longer-term performance through a rate cycle is more relevant. Through this lens, the potential benefits of CLOs through different market environments is evident. All CLO rating categories, including AAAs, strongly outperformed investment grade bonds, with mezzanine tranches (AA-BB) performing best.

All CLO Rating Categories Outperformed Through the Rate Cycle

Returns shown are cumulative over the indicated date ranges. Source:. VanEck, Morningstar and JP Morgan 10/31/2024: Morningstar. Broad CLOs represented by J.P. Morgan CLO Index, AAA Rated CLOs represented by J.P. Morgan CLO AAA Index, AA Rated CLOs represented by J.P. Morgan CLO AA Index, A Rated CLOs represented by J.P. Morgan CLO A Index, BBB Rated CLOs represented by J.P. Morgan CLO BBB Index, BB Rated CLOs represented by J.P. Morgan CLO BB Index, US IG represented by ICE BofA US Corporate Index, US HY represented by ICE BofA US High Yield Index, Leveraged Loans represented by Morningstar LSTA US Leveraged Loan 100 Index, ST Corp IG represented by ICE BofA 1-5 Year US Corporate Index and ST HY represented by ICE BofA 0-5 Year US High Yield Constrained Index. Past performance is no guarantee of future results. Index performance is not representative of fund performance. It is not possible to invest directly in an index.

Every situation is different, and the reason for rate declines will ultimately drive the opportunity. The current rate cutting cycle, for instance, has so far been characterized by continued economic growth and strong corporate fundamentals, and accordingly, tight credit spreads. Rich valuations may favor a cautious approach in this environment rather than full “risk-on” positioning. Within loans, however, pricing dispersion reflects more challenged fundamentals among certain issuers and sectors. If this becomes a broader trend, spread widening will provide more attractive opportunities than what exists currently. In a more dramatic scenario, such as a “hard landing,” we would expect more dramatic Fed rate cuts and significant widening throughout the capital stack but most acutely in BBB and below. This is when the most attractive opportunities may arise further down in the capital structure, and investors may benefit from both price appreciation and a high level of carry – despite low base rates. This last occurred in 2020 with the onset of COVID, when the Fed cut the policy rate to nearly 0%.

However, one does not need to wait for extreme environments such as 2020 to benefit from the higher spreads that CLOs can provide. CLOs have consistently provided significantly greater spreads versus bonds and loans of the same rating in all rate environments. In other words, CLO investors can earn more while not necessarily taking on additional credit risk.

CLO Investors Can Earn More Without Taking On Additional Credit Risk

Source: JP Morgan and ICE Data Services as of 10/31/2024. Using OAS for corporate bonds and discount margins for CLOs. AAA Rated CLOs represented by J.P. Morgan CLO AAA Index, AA Rated CLOs represented by J.P. Morgan CLO AA Index, A Rated CLOs represented by J.P. Morgan CLO A Index, BBB Rated CLOs represented by J.P. Morgan CLO BBB Index, BB Rated CLOs represented by J.P. Morgan CLO BB Index, B Rated CLOs represented by J.P. Morgan CLO B Index AAA Rated Corps represented by the ICE BofA AAA US Corporate Index, AA Rated Corps represented by the ICE BofA AA US Corporate Index, A Rated Corps represented by the ICE BofA A US Corporate Index, BBB Rated Corps represented by the ICE BofA BBB US Corporate Index, BB Rated Corps represented by the ICE BofA BB US High Yield Index and B Rated Corps represented by the ICE BofA Single-B US High Yield Index. Index descriptions at the end of this presentation. Past performance is not indicative of future results. Index performance is not representative of fund performance. It is not possible to invest directly in an index. This is not an offer to buy or sell, or recommendation to buy or sell any of the securities mentioned herein.

The VanEck CLO ETF (CLOI), launched in June 2022, focuses on investment grade CLOs and offers investors a compelling way to add CLO exposure to their core bond portfolio. For investors seeking greater yield potential and who are able to tolerate additional volatility, the VanEck AA-BB CLO ETF (CLOB) provides a way to access lower rated, or “mezzanine,” tranches between the AAA and equity tranches. Both ETFs are actively managed by PineBridge Investments, which has decades of experience in the CLO market.

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