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Not surprisingly, the Federal Reserve on Wednesday boosted interest rates by 25 basis points, taking the Fed funds rate to north of 5%, marking a 16-year high.
While stocks tumbled on Wednesday, there is some potentially positive news emanating from the central bank’s 10th straight rate hike since March 2022: The most recent one might be the last for awhile. At the very least, the statement from the Federal Open Market Committee (FOMC) didn’t feature language foreshadowing more rate hikes.
“In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook,” according to the FOMC. “The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals. The Committee's assessments will take into account a wide range of information, including readings on labor market conditions, inflation pressures and inflation expectations, and financial and international developments.”
It remains to be seen just how sanguine the near-term climate will turn out to be, but with rates hikes potentially on pause for an extend period, it might be time for advisors to consider some unique income-generating strategies.
Make the CLO Call
One such idea is collateralized loan obligations (CLOs). CLOs offer a combination that’s ideal for this environment: Reduced interest rate sensitivity, above-average yields and attractive spreads.
“A Fed pause means that CLO coupons will likely continue to reset at current high levels for some time, and the yields offered will continue to exceed what can be found in longer duration credit asset classes in the absence of a substantial increase in long-term rates,” notes VanEck’s William Sokol . “Currently, CLOs have a yield of approximately 6.5%, versus 5.2% for investment grade corporate bonds and 4.5% on ‘core’ bonds.”
That 6.5% is an aggregate yield for the broader CLO space, but there’s no denying that’s tempting in its own right and the temptation grows when advisors point out to clients, particularly those in the risk-averse camp, that CLO credit quality is often high. That doesn’t mean CLOs are risk-free, but the asset class isn’t chock full of risk, either. That said, advisors shouldn’t compare these instruments to T-bills.
“Although CLOs have coupons that reset periodically, they have an expected life that is longer–currently 3.8 years,” adds Sokol. “An apples-to-apples comparison to T-bills must therefore assume reinvestment every three months over a 3.8 year period at market implied rates, and as shown below, CLOs currently provide a significant yield pickup over the period.”
Altered Rate Landscape Could Benefit CLOs
CLOs are fixed income assets and like any other, these instruments could benefit from the Fed laying off the rate hikes. Hey, that’s something. Particularly when considering there’s not much visibility in terms of when rate cuts could be in the offing.
“In addition to attractive value from both a yield and spread perspective, we believe that if and when we do actually see a Fed pivot, such an environment may actually provide extremely compelling opportunities in the CLO market, particularly for active tranche managers,” concludes Sokol. “A cut in rates will likely occur as a result of an economic slowdown, which would likely coincide a general widening of credit spreads. As spreads recover following a Fed pivot, there may be opportunities for outperformance in portfolios that can opportunistically add exposure to lower-rated tranches at attractive entry points.”
Bottom line: It may not be the “perfect” to back bonds, but the outlook is improving and it could pay to something more rewarding than aggregate bond funds. CLOs fit the bill.
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