Investment Themes: Navigating a rising interest rate environment – Advice Eating

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Expected rate hikes

In late 2021, amid inflation concerns, the Federal Reserve (the “Fed”) announced an end to its bond-buying program and at the March 16, 2022 Fed meeting, raised interest rates by 0.25% for the first time in three years. The current inflation rate in the US is around 8.0%.1 After years of unusually low interest rates, the market has been expecting the Fed to hike rates and this month’s rate hike was in line with those expectations.

With the market anticipating multiple rate hikes, and indeed on March 16th Fed Chair Jerome Powell hinted at potentially six more hikes over the course of the year to combat inflation, it’s possible that in 2022 we could see a cumulative rate hike of 1.50% will experience .2 This paper focuses on access to CLOs and how they can serve as an attractive alternative to other types of credit in times of rising interest rates.

Fed Funds Overnight Rate is expected to rise in upcoming central bank meetings

Cumulative rate hikes expected

Source: Bloomberg

Note: From price date 03/09/2022. Expected cumulative interest rate increases represent the number of cumulative increases (+) or decreases (-) estimated by the associated session. This is calculated as the implied interest rate change divided by the assumed interest rate change. The implied interest rate represents the overnight interest rate expected after the relevant central bank meeting, which is implied by the chosen instrument. Past meeting on 03/16/2022. Future meetings are shown from 05/04/2022 to 02/01/2023.

CLOs and Access to Investment

XA Investments LLC (“XAI”) believes that adjustable rate loans and Collateralized Loan Obligations (CLOs) are compelling investment options in today’s environment of rising interest rates. The XAI Octagon Floating Rate & Alternative Income Term Trust (“XFLT” or the “Trust”) is a listed closed-end fund3 investing in a portfolio of adjustable rate loans, CLO debt and equity. As of December 31, 2021, the Trust’s portfolio was invested in CLO debt and equity (50%), senior and subordinated loans (46%) and other investments (4%). CLO investing introduces a new set of opportunities and risks for investors. XAI believes that the Trust could benefit from its investment in floating rate securities and low average effective duration of less than six months during a Fed tightening cycle. The Trust may also benefit from its active management during such a period of rising interest rates.

For some time, exposure to adjustable rate loans has been accessible through a range of mutual funds, ETFs and closed-end funds. Therefore, advisors and investors have become familiar with loans, their risks and benefits. Conversely, CLOs are less well known and far more difficult to access. With interest rates expected to rise from historically low levels, many investors may find the CLO market’s floating rate coupons attractive.

CLOs can provide a natural hedge against rising interest rates due to their floating rate income and low duration risk.4 When interest rates rise, CLO debt pays higher coupons. CLO equity securities are more nuanced; Over the long term, the “spread” paid to shareholders often increases as interest rates rise. In contrast, interest rates on traditional fixed income investments are locked or “fixed” and are therefore adversely affected by rising interest rates.

CLOs and their reaction to changes in interest rates

CLO bond tranches typically offer higher yields compared to similarly rated corporate bonds and other structured products. They can also offer potential for capital preservation through structural protection and investor-focused arrangements. Historically, the CLO structure has proven to be extremely resilient through multiple market cycles. In fact, there has never been a documented default on the AAA and AA-CLO debt tranches.5 Negative correlations to US Treasuries and low correlations to investment-grade corporate bonds and equities also offer valuable diversification benefits. Finally, CLOs provide access to a broader range of debt issuers, most of which do not participate in the high yield bond markets.

In a CLO, the collateral manager purchases a portfolio of floating rate loans (typically 150-300 issuers) with the proceeds from the issuance of CLO bonds and CLO shares. Interest income from the Adjustable Rate Loans or the “Loan Collateral Pool” will be used to pay coupon interest on the CLO Debt Instruments. Once the interest payments are made and the CLO’s operating expenses are paid, any remainder or residual cash flow is distributed to the CLO stock or “residual” holders. In particular, these equity investors will be the first to absorb any losses from the loan portfolio and reduce such residuals.

CLOs may be attractive to investors concerned about the impact of rising interest rates on credit instruments. As previously mentioned, the bank loans purchased from a CLO Collateral Agent are floating rate and can be particularly beneficial for investors anticipating a rate hike. If interest rates rise, the interest paid on the underlying loans may increase, ultimately benefiting the CLO – particularly the CLO shareholders.

Rate hikes and the impact of LIBOR/SOFR floors

Most loans in the market have LIBOR (or SOFR) floors (ie 50 to 75 basis points).4 This means that if interest rates rise, there may be a delay in the rise in loan yields if the loans are already paying out the minimum or minimum interest rate. Interest rates need to rise above the floors for investors in adjustable rate loans to see the benefit of rate hikes. If we observe multiple interest rate hikes that cause the credit market to move above the floors, the lending rates will adjust with future interest rate changes.

The table at the top of the following page summarizes the performance of various asset classes over the past five cycles of Fed tightening. While accurately predicting interest rate movements is challenging, history can serve as a guide. As interest rates rise, adjustable-rate loans and CLO bonds have the potential to outperform longer-duration fixed-rate bonds such as investment-grade bonds, municipal bonds, and high-yield bonds.

Adjustable rate lending and CLO debt will fare better as the Fed hikes rates

Performance during past Fed tightening periods

date range

ratehike(bps)

US

treasuries

investmentClass recognition

CommunityBind

High yield

Floating rateloan

CLO Debt (BB rated tranches)

2/4/94 to 2/1/95

300

-7.65%

-3.93%

-3.56%

-1.74%

9.33%

n / A

6/30/99 to 5/16/00

175

2.99%

0.10%

-0.16%

-2.27%

3.06%

n / A

06/30/04 to 06/29/06

425

8.59%

5.85%

9.30%

14.88%

5.92%

n / A

12/16/15 to 12/31/18

225

7.93%

8.95%

7.82%

20.02%

14.75%

36.63%

Source: US Treasuries represented by the Bloomberg US Long Treasury Total Return Index, Investment Grade Credit represented by the Bloomberg US Credit Index, Municipal Bonds represented by the Bloomberg US Municipal Index, High Yield represented by the Bloomberg US High Yield 1% Issuer Cap Index, adjustable rate loans, represented by the Credit Suisse Leveraged Loan Index. CLO Debt is represented by the JP Morgan Collateralized Loan Obligation Post Crisis BB Index (“CLOIE”). The data for indices are valid until the end of next month. CLOIE Index launched on December 30, 2011.

Benefits of investing in CLOs

The table below summarizes many key attributes of CLO securities as compared to various other credit and structured securities. However, CLO investing involves important risk considerations, including risk of loss, accounting and valuation risk, leverage risk and market volatility risk. See page 4 for a discussion of the risks associated with CLO investing.

Attractive returns

CLO bonds offer an opportunity for additional yield premium compared to similarly rated bonds and other structured securities6

Low historical failures

CLO bond tranches have historically shown lower default rates over the long term than similarly rated US corporate debt instruments5

variable income

Coupon floats based on LIBOR (or the new market standard SOFR), which can benefit investors in times of rising short-term interest rates7

Portfolio diversification

CLO bonds have low correlation to equities and investment grade corporate bonds and negative correlation to US Treasuries

Protection against inflation

Floating rate loans and CLO securities can act as inflation hedges in the portfolio. These floating rate investments have a higher inflation correlation than other inflation hedges such as commodities or infrastructure


footnotes

1 According to the US Bureau of Labor Statistics Consumer Price Index, 12-month percentage change for the year ended January 2022.

2 Bloomberg.

3 Closed-end funds (CEFs) are actively managed portfolios and are subject to active management risk. Shares of CEFs often trade at a discount to their net asset value. An investment in a CEF involves investment risk, including the possible loss of the entire principal amount invested.

4 Senior secured loans have benchmark interest rate floors (typically tied to LIBOR or increasingly SOFR); The most common LIBOR floor was 0.50%. Investors in senior secured loans benefit from higher interest payments once LIBOR is above the 0.50% floor. Similar levels are expected to persist when benchmark interest rates switch to SOFR.

5 ©1993-2017 Moody’s Investors Services, Inc., Moody’s Analytics, Inc. and/or their licensors and affiliates – used with restricted permission, Moody’s Investors Services, Special Comment: Default and Loss Rates of Structured Finance Securities: 1993-2017. 6 November 2018. Please note that this is the latest information available from Moody’s.

6 JP Morgan, Credit Strategy Weekly Update: High Yield and Leveraged Loan Research, February 11, 2022.

7 Citi Research, “2022 Global CLO Outlook” (December 14, 2021).


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Editor’s note: The summary bullet points for this article were selected by Seeking Alpha editors.

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