Over the past fifty years, fixed income investment strategies have primarily revolved around holding combinations of Municipals, Corporates, Treasuries, and Agency Mortgage-Backed Securities. While additional products like Preferreds have occasionally been included, the core investment approach has largely remained consistent, particularly during periods of disinflation and slow nominal growth. However, evolving economic factors such as deglobalisation, budget deficits, labour shortages, and underinvestment in commodities and infrastructure are now shaping a landscape of higher rates and greater volatility. This shift calls for a more flexible and adaptive approach to fixed income investing.
As we move into a new economic cycle, investors rebalancing their fixed income portfolios face challenges. Index-focused funds, for instance, typically allocate a significant portion (25-35%) to investment-grade corporate bonds, which are increasingly offering poor relative value due to historically tight spreads. This creates a pressing need for alternatives that provide better returns and lower downside risk.
Recent innovations in financial products have made advanced strategies accessible to individual investors. Fixed income ETFs now offer retail investors low-cost, highly liquid access to markets that were once dominated by hedge funds and institutional managers. Among these, Collateralised Loan Obligations (CLOs) stand out as a compelling option, particularly in an environment of rising rates. CLOs have proven to be a valuable tool for navigating post-COVID economic conditions, offering flexibility and attractive yields. Should market dynamics shift, the liquidity of CLO ETFs ensures investors can adapt their portfolios with ease.
CLOs, introduced in 1992, were traditionally available only to banks and large institutional buyers. They pool corporate loans, dividing cash flows among investors based on tranches that provide varying levels of risk protection. These loans, primarily floating rate and sub-investment grade, offer coupons that are competitive with traditional high-yield corporate bonds but with less duration risk and stronger structural protections.
Compared to high-grade and high-yield corporate bonds, CLOs currently present an attractive opportunity. They provide the benefits of high-quality corporates without the drawbacks of inflated valuations. Moreover, their sensitivity to earnings cycles and their structure make them a sound choice in the current environment, particularly for those seeking high yields and reduced default risks.
CLOs differ significantly from Collateralised Debt Obligations (CDOs), which were central to the 2008 financial crisis. Unlike CDOs, which were tied to subprime housing debt, CLOs are backed by diversified corporate loans and include robust covenants and structural safeguards. These protections significantly reduce default risks, making CLOs a safer and more resilient investment option within the fixed income market.
While CLOs may not suit every economic scenario, their adaptability and structural advantages position them as a valuable tool in modern fixed income portfolios. As economic cycles evolve, investors now have more options than ever to navigate changing conditions effectively.
Volta Finance Ltd (LON:VTA) is a closed-ended limited liability company registered in Guernsey. Volta’s investment objectives are to seek to preserve capital across the credit cycle and to provide a stable stream of income to its Shareholders through dividends that it expects to distribute on a quarterly basis.
