by Miguel Ramos Fuentenebro, Co-founder, Fair Oaks Capital
In today’s financial environment, where interest rates have experienced unexpected fluctuations, investors are increasingly turning to floating-rate products as a strategic means to secure stable returns.
One of the primary advantages of these floating-rate products, is their ability to adjust yields in line with prevailing interest rates. This provides investors with a natural hedge against the risk of rising rates, which has been a central concern in fixed income markets.
The Growing Appeal of Floating-Rate Products in a Shifting Interest Rate Environment
Despite their “risk free” label, 10-year UK government gilts lost over 30% of their value between September 2021 and September 2022 due to rising rates. This highlights the growing need for rate-insensitive instruments and mirroring the longer-standing practice in the US, where floating-rate products have been an integral part of fixed-income portfolios.
Products like AAA-rated Collateralised Loan Obligations (CLOs) are gaining attention for their attractive yields and reduced sensitivity to interest rate duration risk
Why AAA CLOs have Built Up an Impressive Track Record
AAA-rated CLOs are particularly attractive because of their robust structure and resilience during periods of market stress. AAA CLOs have maintained an impressive track record, with zero defaults recorded since data started in 1997.
This history of stability through various economic cycles, including the 1998 Asian crisis, 2000 Dot-com bubble, 2008 financial crisis and the recent pandemic, underscores their ability to withstand severe economic pressures.
Moreover, AAA CLOs are designed to protect against idiosyncratic defaults that typically affect corporate bonds. They are backed by diversified portfolios of loans, and the senior tranches benefit from substantial credit enhancements. As a result, AAA CLOs offer not only higher yields than similarly rated corporate bonds but also a lower risk of loss in times of financial distress.
The Rising Popularity of AAA CLO ETFs
US investors have long embraced floating-rate products, particularly in the form of lower-rated instruments such as bank loans. These products have offered higher returns but come with increased credit risk. The launch of AAA-rated CLO ETFs has provided investors with a lower-risk, high-yield alternative that still benefits from the floating-rate structure. The largest of these US ETFs, JAAA, which had a modest $377 million in assets under management at the end of 2021, has now risen to over $13 billion. Unfortunately, US ETFs are often not available or efficient for UK based investors (or investable by UK institutions given UK securitisation regulations).
The reasons for the appeal of US AAA-rated CLO ETFs (zero default record, higher yields compared to government and corporate bonds, floating-rate nature, liquidity, transparency, and ease of trading) are similarly compelling to UK investors and, to meet this demand, Fair Oaks listed the first European AAA CLO ETF on the London Stock Exchange this September.
The launch of the Fair Oaks AAA CLO ETF (FAAA) addresses the gap in the European market. This ETF, fully compliant with UK securitisation regulations, offers UK investors access to floating-rate
European AAA-rated CLO tranches, which are currently offering spreads of approximately 1.3% over three-month Euribor, translating to attractive yields of around 6.4% in GBP.
Furthermore, over the last five years, AAA CLOs have experienced volatility well below short-duration gilts (2.5% compared to 6.1%) and equal to that of German 2-year government bonds.
Opportunities for Wealth Managers and Fund Selectors
For UK wealth managers and fund selectors, incorporating floating-rate products like AAA CLOs into portfolios offers multiple advantages.
Beyond mitigating interest rate risk, these products enhance yield potential while offering reliable, low volatility returns. In a world where traditional fixed-income strategies are being challenged by changing monetary policy, CLOs provide a way to safeguard returns while navigating the uncertainties of the current market environment.
AAA-rated CLOs are not just valuable for fixed-income strategies but also as a tactical option for cash management or a high-yield substitute for short-duration bonds. With higher yields than short-term government bonds and protection from interest rate fluctuations, AAA CLOs offer a flexible way for wealth managers to preserve capital and generate returns in volatile market conditions, while avoiding the potential rate or credit-driven losses of government or corporate bonds.
Looking Ahead: Floating-Rate Products as a Core Strategy
As interest rate and economic uncertainty persists, the role of AAA-rated, floating-rate products in investors’ portfolios is expected to grow. Their ability to offer higher returns while mitigating interest rate and credit risk makes them an important tool for wealth managers and institutional investors alike.
Recent events, such as the US elections and UK budget have further supported floating-rate products and we believe that AAA CLOs are particularly well-positioned to provide a flexible and defensive strategy in the current market environment.
