Investors stepped up their risk appetite on the bonds side in June, pursuing the prospect of higher yield as Federal Reserve policy remains uncertain, according to data from State Street. Last month, fixed income exchange traded funds saw nearly $25 billion in flows, with investors ramping up exposure to long-term government bonds to the tune of more than $6 billion, the asset manager found. However, investors were also content to ramp up credit risk, directing more than $1.6 billion into ETFs with underlying bank loans and collateralized loan obligations, State Street found. “Those funds have now had 13 consecutive months with inflows, taking in over $18 billion during that time frame as investors seek out exposures with limited rate volatility amid elevated rate risks from evolving monetary policy,” wrote Matthew Bartolini, head of SPDR Americas Research at State Street Global Advisors, in a report last week. Chasing yield Both bank loans and CLOs are plays on today’s higher interest rate environment. Big institutional investors can purchase bank loans – which lending institutions make to companies – and benefit from the loans’ floating coupon rate. These coupons offer attractive yields as rates stay high. The bank loans are typically below investment grade, but they are secured by the assets of the borrower – and that typically means the lender is at the top of the list to get paid in the event the borrower goes bankrupt. CLOs are similar to bank loans: These are pools of floating rate loans made to businesses, which can be non-investment grade. The CLO itself is made up of tranches that each have their own corresponding risk characteristics. Top-ranked CLOs – those deemed AAA by ratings agencies – are first in line to get paid if a borrower goes bankrupt. Though the floating rate component of these assets allows them to fare well in a rising rate environment, investors may see their income decline once the Fed begins to dial back its policy. Snapping up actual bank loans and CLOs is beyond the means of individual investors, but they can get exposure to the space through ETFs. Though these strategies shouldn’t make up the lion’s share of an investor’s fixed income allocation, they can be a small component of a diversified portfolio. For instance, the BlackRock Floating Rate Loan ETF (BRLN) has an expense ratio of 0.55%, and a 30-day SEC yield of more than 8%. In the CLO space, the Janus Henderson AAA CLO ETF (JAAA) has emerged as a popular choice with nearly $5.4 billion in flows in 2024, per FactSet. It has an expense ratio of 0.21%, and a 30-day SEC yield of 6.6%. Knowing your risk Investors’ pursuit of yield is happening at a time when the economy is strong, earnings are growing and ratings momentum is improving, Bartolini told CNBC in an interview. “We now finally have more upgrades relative to downgrades across high yield and investment-grade rated bonds.” He also noted that though investors may deem bank loans and CLOs to be inherently risky due to their exposure to below-investment grade borrowers, they should keep an eye on the risk of rate volatility elsewhere in their portfolios while Fed policy remains uncertain. Bank loans and CLOs tend to have less price sensitivity to changes in rates, meaning that they are short duration. Fixed income assets with longer maturity dates tend to have greater duration – and could be more likely to see a swing in prices when rates change. “Rate volatility is one of the bigger risks in the bond portfolio right now,” said Bartolini. “Rate policy is evolving and uncertain, and it’s unlikely to be less cloudy as we get into the summer months.”
