By Miguel Ramos Fuentenebro, Co-founder, Fair Oaks Capital
In today’s environment of ever-changing interest rate expectations, investors and financial advisors are increasingly turning to floating-rate products as a strategic response to generate stable returns.
These strategies offer a novel way to navigate uncertainty, and although they have long been popular in the United States, interestingly at Fair Oaks Capital we are finding they are now gaining significant traction in the United Kingdom, and Europe, as well. In particular, Discretionary Fund Managers (DFMs), and Independent Financial Advisors (IFAs), are using these products as a flexible way to navigate today’s volatile interest rate environment while, still offering attractive returns.
Rising Trend in UK Fixed Income amid Interest Rate volatility
With central banks worldwide adjusting monetary policies, fixed income investors face significant challenges. We are seeing longer-duration assets trading at rates suggesting significant interest rate cuts, which could restrict investors’ potential gains if this situation continues. Additionally, if central banks do not meet market expectations, these assets could experience mark-to-market losses.
This is why floating-rate products offer a compelling solution, as their yields adjust in line with prevailing interest rates. This provides a natural hedge against rate increases and allows investors to focus on the credit risk associated with the investment rather than interest rate risk.
Floating-rate strategies in the UK
The slower adoption of floating-rate products in the UK compared to the US can be attributed to several factors including market familiarity. The US fixed income market has a longer history with floating-rate products, whereas UK investors have tended to be more conservative, relying on traditional fixed-rate securities.
Another challenge may have been limited availability. Until recently, UK managers had few options for highly rated (AAA) floating-rate investments, primarily being restricted to asset-backed securities. This scarcity may have hindered broader adoption until recently, and now we are seeing the landscape is changing, as more investors understand the benefits of these strategies.
The rise of AAA Floating-Rate CLO ETFs in the US and UK
Recognising the growing demand for AAA-rated, floating-rate products, several asset managers have launched ETFs that offer investors efficient access to CLO AAA notes through an ETF wrapper.
In the US, for example, the largest AAA CLO ETF, JAAA has grown from $378 million in AUM at the end of 2021, to $13 billion today. Today, US investors have access to eleven ETFs investing in CLO bonds[1]. This development allows investors who may not have the resources to invest directly in CLOs to gain exposure to these assets. ETFs provide liquidity, transparency, and ease of access, making them an effective vehicle for incorporating floating-rate strategies into a diversified portfolio.
However, most UK (and EU) institutional investors can’t invest in these US ETFs since US CLOs do not comply with UK and EU securitisation regulations. US ETFs can also be tax-inefficient for UK investors.
To meet this challenge, Fair Oaks launched Fair Oaks AAA CLO ETF, an ETF listed in London (FAAA) and Frankfurt (LAAA). This ETF invests exclusively in AAA-rated CLOs which are fully compliant with UK and EU securitisation regulations and can be traded in GBP.
AAA-Rated CLOs: high returns with lower risk
The consistent performance of AAA-rated CLOs through various economic cycles, including periods of financial stress like the 2008 financial crisis, underscores the robustness of these instruments.
Indeed, AAA-rated Collateralised Loan Obligations (CLOs[2]) have demonstrated remarkable resilience, recording zero defaults since data collection began in 1997.
Even if interest rates rise, these investments can still deliver stable returns while mitigating risks associated with economic fluctuations. This reliability enhances the appeal of floating-rate products, enabling investors to benefit from rising yields while feeling secure in the underlying credit quality of their investments.
Attractive Yield profile
Despite their AAA credit rating and robust default performance, newly issued AAA-rated CLOs offer yields that are typically associated with BBB-rated instruments rather than AAA-level risk profiles.
For example, as of October 2024, newly issued European AAA-rated CLO tranches were offering spreads of approximately 1.3% over three-month Euribor, resulting in attractive current yields (6.4% in GBP). This yield advantage, combined with their floating-rate nature, makes them particularly appealing in the current market environment[3].
Low volatility
The annualised volatility of European AAA-rated CLOs is comparable to that of government bonds with similar durations and meaningfully lower than that of AAA or AA rated corporate or financial bonds[4]. As a less volatile asset, CLOs have the potential to provide more consistent and predictable returns, aiding in portfolio planning and cash flow management.
Looking Ahead: The future of Floating-Rate Products in UK portfolios
As interest rate uncertainty continues to persist, the role of floating-rate products in UK fixed income portfolios is set to expand. We firmly believe that DFMs and IFAs are increasingly recognising the value these strategies offer—not only as a hedge against interest rate risk but also for their potential to deliver enhanced yields compared to traditional fixed-rate products.
Additionally, floating-rate products provide crucial diversification benefits within fixed income allocations.
The emergence of ETFs focused on high-quality floating-rate assets, particularly AAA-rated CLOs, is set to further accelerate this trend, democratising access to these strategies for a wider array of investors.
[1] Source: ETFcentral.com as of 9-Oct-24
[2][2] A Collateralized Loan Obligation (CLO) is a type of structured financial instrument similar to a Residential Mortgage-Backed Security (RMBS), but instead of pooling residential mortgages, it pools together corporate loans. The pooled loans are managed by a professional asset manager and then divided into tranches with different risk and return profiles. The CLO notes are generally rated by one or more of Moody’s, Standard & Poor’s or Fitch.
[3] As of 11-Oct-24
[4] The annualised volatility, over the last five years, of European AAA CLOs has been 2.5% compared to 2.3% for the 2-year German bund (2.3%), 6.0% for 2-year Gilt and 3.3% for AAA financials.
Jesse Pitts has been with the Global Banking & Finance Review since 2016, serving in various capacities, including Graphic Designer, Content Publisher, and Editorial Assistant. As the sole graphic designer for the company, Jesse plays a crucial role in shaping the visual identity of Global Banking & Finance Review. Additionally, Jesse manages the publishing of content across multiple platforms, including Global Banking & Finance Review, Asset Digest, Biz Dispatch, Blockchain Tribune, Business Express, Brands Journal, Companies Digest, Economy Standard, Entrepreneur Tribune, Finance Digest, Fintech Herald, Global Islamic Finance Magazine, International Releases, Online World News, Luxury Adviser, Palmbay Herald, Startup Observer, Technology Dispatch, Trading Herald, and Wealth Tribune.