Many investors are increasingly seeking to protect their portfolios from the looming threat of higher inflation. Against this uncertain backdrop, I believe collateralized loan obligations (CLOs) can provide one source of refuge given their floating-rate coupons (yields), which would rise as short-term interest rates moved higher. Attractive current income relative to other credit assets and broadly positive CLO fundamentals further bolster my conviction in this often-overlooked asset class.
Where I stand on the inflation debate
Core US inflation spiked sharply in April and May 2021. For the three-month period ended in May, the Consumer Price Index (CPI) rose by 8.3% annualized, the biggest gain since the early 1980s. This has naturally exacerbated recent inflation concerns, raising questions around whether higher inflation will be transitory or more sustained. US interest rates have risen amid expectations for higher inflation, resulting in negative total returns year-to-date (through 31 May) for many fixed income sectors, especially longer-dated fixed-rate assets.
My take: While some of today’s inflationary pressures may indeed be short-lived, particularly within economic sectors most exposed to the combination of damaged supply and pent-up “reopening demand” – airfares, cars, and hotels, for example – I think some components of inflation may prove “stickier” in the medium to longer term than the US Federal Reserve (Fed) currently expects.
CLOs can insulate a portfolio from rising inflation
Because of their floating rates, which make them less sensitive to interest-rate moves, I believe CLOs are well-positioned to outperform longer-duration credit assets in a potential rising-rate environment going forward. And history tells the story well: Looking at recent periods of rising rates, CLOs have generated positive total returns and outperformed investment-grade corporate bonds in all instances (Figure 1).
Moreover, should higher inflation persist for longer than the Fed seems to think (again, that’s my take), then it could force the central bank to begin “normalizing” US monetary policy sooner than it currently anticipates. This might include hiking rates as early as next year, which could boost CLOs’ income-return component as their floating-rate coupons rise with short-end rates. The risk to this scenario would be the prospect of negative total returns if sooner-than-expected Fed tightening triggered a “risk-off” market event. While CLO spreads could widen in this case, so too could spreads in other credit sectors.
CLOs feature attractive income and healthy fundamentals
The current income from CLOs stands out to me as being attractive relative to that offered by other securitized and corporate credit assets. In addition, I maintain a favorable outlook for CLOs’ underlying bank loan collateral. In general, I expect bank-loan defaults to remain benign in the medium term – near their historical average, which is in the low-single digits. Credit fundamentals have also continued to improve, with many companies holding sizable cash cushions to absorb the higher interest expense from rising rates.
Bottom line on CLOs
The future path of inflation will continue to be a hotly debated topic in the coming months. Credit investors who think a sustained rise in prices may be in the cards should, in my view, consider CLOs as a potential hedge against higher inflation and interest rates. Taken together with their attractive current income and sound overall fundamentals, I believe CLOs may present a compelling opportunity for inflation-wary investors.