Collateralised loan obligations (CLOs) can be used as a diversification tool and a hedge against interest rate uncertainty, according to a senior KKR credit fund manager.
Jeremiah S. Lane, portfolio manager for KKR’s leveraged credit funds and portfolios, said that CLOs can be a useful tool in credit portfolios at risk from incoming rate reductions.
There has been a growing consensus that interest rate cuts are coming from the US Federal Reserve, the European Central Bank and the Bank of England. This could result in lower yields for credit investors, or for fewer opportunities as banks resume higher-risk lending activities.
Read more: Debt-for-equity swaps soar but exits at 3-year low
However, Lane believes that CLOs can work to offset some of these risks when used within the liquid part of a credit portfolio.
“These floating-rate securities offer attractive carry that can help hedge against the potential for slower or lesser rate cuts, offer a degree of protection in the form of par subordination, and add a source of diversification to a liquid credit portfolio,” said Lane.
“Not only does CLO debt offer similar or better carry to leveraged loans, but it also has a degree of added protection against defaults.”
Read more: KKR eyes “rare opportunity” in Asia’s private credit market
Lane noted that because rated debt tranches benefit from the subordination of equity and lower rated tranches, a CLO portfolio’s par value “can decline significantly before rated debt tranches begin taking a principal loss.” This could effectively reduce rate-related risk for credit investors.
“CLO debt can be an effective way to add an element of diversification to a liquid credit portfolio, in our view,” added Lane.
“Investors are understandably trying to position their portfolios for interest rate cuts after a long period of high inflation and a rapid succession of rate hikes.
“We think it makes sense to supplement the leveraged loan allocation with CLO debt, which offers superior carry on a risk-adjusted basis, important protection against defaults, and diversification potential.”
Read more: Credit ratings for SME CLOs forecast to remain stable despite rising insolvencies
