Financial professionals looking to position client portfolios for rising rates may want to consider shifting a portion of their core bond allocations to collateralized loan obligations (CLOs). Senior Portfolio Strategist Damien Comeaux explains.

Key Takeaways

• Expectations for rising policy rates have caused many financial professionals to rethink how they approach investors’ core fixed income allocations.
• With their low correlations to traditional fixed income asset classes, CLOs may offer attractive diversification benefits.
• Unlike other floating-rate securities such as bank loans, high-quality CLOs carry an investment-grade credit rating while offering a higher yield than U.S. Treasuries and corporate bonds.

For many investors, floating-rate exposure has traditionally been synonymous with bank loans. However, the risk associated with bank loans is that their below investment-grade rating leaves them more susceptible to downside volatility compared to investment-grade debt.

Enter collateralized loan obligations (CLOs), which provide the same floating-rate exposure as bank loans but have the advantage of an investment-grade rating. CLOs are managed portfolios of floating-rate bank loans that have been securitized into different instruments of varying credit risk. Over 80% of CLOs carry a credit rating from A to AAA while offering a higher yield versus Treasuries and corporate bonds along with lower interest rate duration (Exhibit 1).

Source: Bloomberg, as of 31 January 2022. Indices used: Bloomberg U.S. Treasury 1-3 Years Index, Bloomberg U.S. Treasury Index, Bloomberg U.S. Aggregate 1-3 Years Index, Bloomberg US Aggregate Bond Index, Bloomberg U.S. Global Aggregate Index, Bloomberg U.S. Corporate Bond 1-3 Year Index, Bloomberg U.S. Corporate Bond Index, and JP Morgan AAA CLO Index.

Given the unique characteristics of the CLO asset class, the correlation between CLOs and traditional fixed income asset classes such as U.S. Treasuries and the Bloomberg U.S. Aggregate Bond Index has historically been very low (Exhibit 2). For financial professionals who are concerned about their clients’ exposure to those traditional asset classes amid the prospect of rising rates, CLOs’ low correlations may offer attractive diversification benefits.

Source: Morningstar, Bloomberg, as of 31 January 2022.

This diversification is especially important during periods of rising rates, as CLOs offer the potential for a differentiated source of returns. In an environment where interest rates are low and the risk of higher Treasury yields has risen, an allocation to higher-quality CLOs may help investors mitigate interest rate risk. As seen in the chart below, AAA rated CLOs have less sensitivity to rising rates when compared to other core fixed income benchmarks – interestingly, this includes outperforming 1- to 3-year Treasuries and Corporates in three of the four scenarios.

For financial professionals looking to modernize their defensive fixed income tool kit and help position client portfolios for rising rates, shifting a portion of their core bond allocations to CLOs could be a viable solution. High-quality CLOs offer diversification to traditional core bond allocations by providing a competitive yield, a floating-rate component to help neutralize duration risk, and a lower correlation to Treasuries and corporate bonds.