The diversification benefits of adding floating rate CLOs to fixed income portfolios
Portfolio Managers John Kerschner, Nick Childs, and Jessica Shill discuss how adding floating rate collateralized loan obligations (CLOs) to traditional fixed rate bond portfolios may improve risk-adjusted returns.
1 minute read
- With the Bloomberg US Aggregate Bond Index comprising 100% fixed rate debt, investors seeking improved risk-adjusted returns might consider adding floating rate CLOs to their bond allocations.
- Exhibiting ultra-low duration, attractive yields, strong credit ratings, and low combined correlation to equities and fixed income, the addition of CLOs may result in improved risk-adjusted returns.
- As the US Federal Reserve readies itself for more potential rate hikes – and signals that it expects the federal funds rate to remain higher for longer – CLOs stand to benefit from a higher rate regime as their coupons continue to reset in lockstep with changes in short-term rates.
The issue of diversification has roared back to the forefront of investor concerns in 2022, as equity and fixed income markets experienced unprecedented concurrent drawdowns. For many investors, fixed income is considered “the diversifier” to their equity holdings, but disappointingly, they have not seen much diversification benefit from bonds in 2022.
In response, some investors are looking to new asset classes to diversify their portfolios. Liquid alternatives, unlisted real estate, and cryptocurrencies have garnered more attention, and their inclusion in traditional stock-bond portfolios is on the rise. While we believe this form of inter-asset class diversification (diversification between asset classes) provides benefits when done well, we think investors should not overlook the importance of intra-asset class diversification (diversification within asset classes).
Please read the following important information regarding funds related to this article.
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise. This risk is generally greater the longer the maturity of a bond investment.
- The Fund invests in high yield (non-investment grade) bonds and while these generally offer higher rates of interest than investment grade bonds, they are more speculative and more sensitive to adverse changes in market conditions.
- Callable debt securities, such as some asset-backed or mortgage-backed securities (ABS/MBS), give issuers the right to repay capital before the maturity date or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the fund may be impacted.
- If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
- The Fund may use derivatives towards the aim of achieving its investment objective. This can result in 'leverage', which can magnify an investment outcome and gains or losses to the Fund may be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- When the Fund, or a hedged share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency, the hedging strategy itself may create a positive or negative impact to the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- The Fund may incur a higher level of transaction costs as a result of investing in less actively traded or less developed markets compared to a fund that invests in more active/developed markets. These transaction costs are in addition to the Fund's Ongoing Charges.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
- In addition to income, this share class may distribute realised and unrealised capital gains and original capital invested. Fees, charges and expenses are also deducted from capital. Both factors may result in capital erosion and reduced potential for capital growth. Investors should also note that distributions of this nature may be treated (and taxable) as income depending on local tax legislation.
- The Fund invests in Asset-Backed Securities (ABS) and other forms of securitised investments, which may be subject to greater credit/default, liquidity, interest rate and prepayment and extension risks, compared to other investments such as government or corporate issued bonds and this may negatively impact the realised return on investment in the securities.