As we consider the current market environment, investors can use collateralized loan obligations and floating-rate notes related ETF strategies investments to diversify their investment portfolios today.
In the recent webcast, Rise Above Rising Rates with CLOs and FRNs, Fran Rodilosso, head of fixed income ETF portfolio management at VanEck, pointed out that floating rate assets have significantly outperformed this year, and they have provided attractive yields along the way, too. Specifically, CLOs have only dipped -2.7% year-to-date and exhibit a 7.4% yield-to-worst. In comparison, the U.S. Agg declined -14.7% this year and come with a lower 4.7% yield-to-worst.
Bill Sokol, director of ETF product management at VanEck, explained that floating rate notes have outperformed in this rising interest rate environment we have found ourselves in because the asset’s coupons adjust to interest rate changes, which may help reduce price volatility. The coupon is the combined reference rate and spread where the reference rate is typically based on a three-month LIBOR. Additionally, floating rate notes are commonly issued with one-year to five-year maturities, the coupon resets typically occur every three months, and come with near-zero duration.
“Allocating a portion of a core U.S. bond allocation to floating rate notes can significantly reduce a portfolio’s overall interest rate exposure,” Rodilosso said. “Exposure to floating rate notes may provide additional diversification without significant impact to overall yield and coupon.”
In a rising rate environment, Rodilosso contended that floating rate notes provide fixed-income investors an edge over the market. Floating rate notes have near-zero interest rate duration due to the periodic coupon reset feature. In contrast, short-term bonds have an average duration of approximately 2.73, or a much greater interest rate sensitivity. At the same time, short-term bonds have a price sensitivity to credit spreads that is comparable to floating rate notes.
Rodilosso added that bank loans also pay a floating rate coupon similar to floating rate notes. However, bank loans are generally issued by non-investment grade-rated companies so investors may be subject to greater credit risk and return volatility. Loans are generally more illiquid than floating rate notes because they trade by assignment and can be subject to extended settlement timeframes.
As a way to capture this floating-rate note market segment, investors can look to something like the VanEck Vectors Investment Grade Floating Rate (NYSEArca: FLTR). The fund provides exposure to the MVIS US Investment Grade Floating Rate Index. The underlying index is comprised of floating rate notes, which have variable coupons that reset periodically, and is mainly made up of a non-leveraged portfolio of investment grade floating rate corporate bonds. These floating rate notes may offer higher yields than other short-duration instruments.
“FLTR’s index is designed to provide higher yield potential versus the broad floating rate note market,” Sokol said.
The ETF “tends to outperform when credit spreads narrow and underperform when spreads widen, due to higher spread duration versus a market capitalization-weighted index.”
The underlying index has also consistently outperformed over the long term. The MVIS US Investment Grade Floating Rate Index has had an impressive batting average against the Bloomberg US FRN < 5 yrs, outperforming 100% of the time over the 10-year rolling period.
Sokol also underscored the potential protection that CLOs offer against a rising interest rate environment. CLO coupons adjust based on a reference rate (SOFR/LIBOR) and therefore have lower duration risk versus similarly rated fixed income alternatives. Additionally, the floating rate coupons may make CLOs potentially attractive in an environment of elevated inflation, such as the one we are currently experiencing.
Sokol noted that this is not some fringe or niche market segment as CLOs are an integral part of the global financial market, making up a $1 trillion market. CLOs are not a niche asset class as they have gained widespread institutional adoption. The global CLO market reached the $1 trillion benchmark size in mid-summer 2021. Meanwhile, the total principal outstanding was $875 billion for U.S. CLOs and €187 billion for European CLOs. U.S. CLOs even represent 64% of the total U.S. leveraged loan market.
CLOs are a securitized pool of senior secured loans. Specifically, CLOs hold floating-rate, secured loans which have seniority over other claimants in the event of insolvency. Assets are financed by multiple tranches of debt with different seniorities and an equity tranche. Cash flows from the loan portfolio are paid sequentially starting with the most senior tranche.
Moreover, risk-averse investors may like to know that CLOs benefit from multiple structural protections or built-in risk protections. CLO managers analyze issuers and apply sector expertise to construct portfolios, with fees generally linked to performance. Subordinated tranches absorb losses first. CLOs also have features that are protective of debt tranches. Lastly, excess income compared to interest paid on debt tranches protects in case coverage tests are not met, which can be used to buy additional assets or pay down notes.
Relative to other structured products, CLOs are significantly more resilient, such as what we have witnessed during the Global Financial Crisis. CLOs also come with relatively low default rates, with annual global default rates of just 1.7% for the riskiest BB-rated CLOs.
To help investors access the CLOs market, VanEck recently launched the VanEck CLO ETF (CLOI), which is sub-advised by PineBridge Investments.
Looking at PineBridge’s CLO tranche investment philosophy, they manage the downgrade/default risk of a CLO tranche, monitor CLO-specific metrics for early warning of credit deterioration, utilize the entire capital stack in a CLO to add alpha during periods of volatility, and utilize PineBridge specialists to inform top-down positioning. The PineBridge process includes CLO manager due diligence, re-underwrite CLOs, construction of a portfolio, and ongoing risk monitoring.
Financial advisors who are interested in learning more about CLOs and FRNs can watch the webcast here on demand.