The U.S. Federal Reserve recently implemented a significant interest rate reduction, and another 50 basis point cut is expected in November, with further cuts on the horizon. Despite these declining rates, investor demand for floating-rate investments, including senior loans, private credit, and collateralized loan obligations (CLOs), has been rising.
While interest rates are dropping, it’s widely believed that a return to the zero-rate environment of the post-Global Financial Crisis (GFC) period is unlikely. In fact, many investors think the market is overly pessimistic about U.S. growth prospects, and that rate cuts will be more gradual than anticipated. Even with the prospect of a long-term neutral rate settling around 2.75% to 3.25%, the all-in yields on floating-rate securities remain appealing, especially given their wider spreads compared to fixed-rate bonds. This spread is partly due to the liquidity, complexity, and unfamiliarity of certain floating-rate investments, which offer a cushion against declining risk-free rates.
The size of floating-rate markets like senior loans and CLOs is now comparable to the high-yield bond market, but they lack a long history in a typical interest rate environment. Investors, however, recognise their value when interest rates are falling from high levels to more moderate ones. Another reason for their appeal is that, while rates are decreasing due to economic slowdown concerns, floating-rate investments tend to be more senior in capital structures, often secured against assets, and come with stronger investor protections compared to other bond market securities.
CLOs, in particular, have caught investors’ attention. These securities package a diverse portfolio of loans and allocate coupon payments to different tranches according to a waterfall structure. Higher-risk tranches receive higher returns, but only after lower tranches have been paid. This hierarchy provides additional credit enhancement, benefiting investors by amplifying the effect of diversification. Even the lower-rated BB CLO tranches typically have a substantial buffer of subordinate equity, reducing the likelihood of losses. As a result, the cumulative default rate on BB CLO tranches has remained low, with mezzanine tranches trading at a considerable premium compared to similarly rated bonds.
Throughout various financial crises, including the GFC and the 2015-2016 energy crisis, CLOs have demonstrated resilience. Investors who held their positions avoided cash losses despite price volatility. As floating-rate investments grow more mainstream, it is anticipated that some of the volatility in CLOs will decrease, fostering a virtuous cycle of larger portfolio allocations and further stability. This may eventually lead to these assets being priced similarly to better-known fixed-rate investments.
For now, CLOs and other floating-rate securities continue to offer an attractive opportunity compared to fixed-rate options, despite declining rates. This explains why many investors are eager to add them to their portfolios, even as the Federal Reserve signals further rate cuts.
Floating-rate investments, especially CLOs, present a compelling opportunity in the current rate environment. Despite declining interest rates, the combination of wider spreads, credit enhancement, and investor protections makes these securities appealing. As they continue to gain popularity, their role in diversified portfolios will likely expand, adding stability and growth potential in a changing financial landscape.
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.
