In 2024 cheaper valuations relative to corporate credit and a strong economy enticed corporate bond investors to add securitized assets to their portfolios. The move produced positive returns, while static bond indices like the US. and Global Aggregate Bond Indices lagged, according to fixed-income executives at Janus Henderson.
It was a critical lesson for investors: Securitized assets continue to offer opportunities for generating returns and fortifying portfolios, especially now, as markets anticipate higher-for-longer inflation and slower rate cuts. Investors should take advantage of higher yields on offer for short-term notes.
The best portfolio management strategy is not as simple as choosing short-term investments, however.
Despite occasional drawdowns, AAA CLOs have still ended up comfortably ahead of cash.
It's much better to favor AAA-rated CLOs (https://asreport.americanbanker.com/news/inflation-uncertainty-benefits-clo-market) over short-duration investment grade bonds or cash/money market funds, John Kerschner, head of U.S. securitized products suggested in a note titled "Do AAA CLOs still make sense in a declining rate environment?"
In a low-interest rate environment, CLOs outperform with their floating rates, which look better compared to cash or money market funds—or both—which pay nothing when rates go to zero.
"Historically, despite occasional drawdowns, AAA CLOs have still ended up comfortably ahead of cash over the long term," Kerschner wrote.
AAA CLOs have also outperformed short-duration investment-grade (IG) corporates. Janus Henderson compared the J.P. Morgan CLO AAA Index (January 2015 – January 2025) with the Bloomberg U.S. investment-grade Corporate 1-3 Year Index and the Bloomberg U.S. Treasury Bills: 1-3 Months Index (representing Cash/Money market funds). Of the three indices, CLOs returned the highest yield the asset management firm found.
Comparing the credit rating of bond and CLO indices, Janus Henderson found that the AAA CLOs' index outperformed short-duration IG corporates. According to Bloomberg and S&P index data as of January 24, 2025, the average credit rating for the AAA CLO index was AAA compared to A- for short-duration IG corporates. Additionally, CLOs were slightly less volatile than short-duration IG corporates, so they could be used to increase yield while beefing up the overall credit quality of their portfolios, the asset management firm suggests.
"We believe a strategic allocation to AAA CLOs, with their attractive floating-rate yields, high credit quality, and low correlation to other fixed income sectors, remains a key component of a strategic fixed income allocation," Kerschner wrote.
Investors would be better served over the long term by taking on a small amount of volatility to improve their portfolio's income earning potential.
Put to the test
In a hypothetical exercise, Janus Henderson added AAA CLOs to the Bloomberg U.S. Aggregate Bond Index (U.S. Agg). Ten-year annualized return and standard deviation both improved progressively as increasing amounts of CLOs, rising from zero to +10%, +20% and 30% of the portfolio balances, were added.
"In our view, aside from maintaining a modest cash allocation for immediate needs (0-3 months), we believe investors would be better served over the long term by taking on a small amount of volatility to improve their portfolio's income earning potential," Kerschner said.
Winnie Cisar, global head of strategy at Fitch Ratings CreditSights, a Fitch Solutions company, also favors floating-rate corporate credit products and expects CLOs to outperform because of their ability to manage interest-rate volatility and potential inflation.
"They offer a regular income above their reference rate and do well in a steady interest rate environment," she told Asset Securitization Report. "Our forecast is that the Fed is not going to be aggressively easing this year. So, if the Fed holds policy rates at 4.5% this year, then a CLO will earn 4.5% plus maybe a 100-basis point spread, making 5.5%."
In the longer term, floating-rate assets offer a form of hedge against inflation.
"If the long end of the Treasury curve rises, fixed income investors will lose money, but income from floating-rate assets will rise," Cisar said.
Consumer ABS
Janus Henderson is optimistic about U.S. consumers' financial health, although they hold a record $1 trillion burden of credit card debt and other revolving credit plans, in a note titled "Key trends driving U.S. securitized fixed income in 2025" by Kerschner and John Lloyd, lead for multi-sector credit strategies and portfolio manager at Janus Henderson.
Middle- and upper-income households, which account for 85% of consumer spending, have benefited from rising stock portfolios and home values, plus low levels of employment and rising wages. According to Q2 figures from the Federal Reserve's Board of Governors, the debt service ratio of these consumers is within the pre-Covid range and is well below the levels reached in the run-up to the Global Financial Crisis.
To hedge against longer-term recession and possible lower interest rates, and to fortify portfolios, investors could complement their short-duration holdings with a long-duration asset that carries almost no credit risk, such as agency MBS. Lloyd and Kerschner consider agency MBS to be trading cheap relative to Treasuries and investment-grade corporates.
CMBS
In a post-Covid-19 environment, the office real estate market has been improving. Also, investors have been moving back, lifting excess returns for non-agency CMBS. For the year to mid-November 2024, annual excess returns were higher than they had been for a decade. Comparing CMBS and corporate bond indices, Kerschner finds better credit quality and wider spreads in CMBS. The Bloomberg U.S. CMBS Investment Grade Index had an average credit agency rating of AAA/AA+, as of Nov. 15, 2024, compared to a rating of AA/AA for the Bloomberg AA Corporate Index. This was combined with a credit spread of 95 basis points for CMBS, well wide of their 10-year tightest levels of 62 bps, compared to 40 bps for corporate bonds.
Even after the strong excess returns in 2024, the CMBS sector has more runway for outperformance, Kerschner concludes.
CreditSights' Cisar, however, cautions against constructing a forecast based on fixed-income assets' strong showing in 2024. Changing macroeconomic conditions, Federal Reserve interest rate expectations, and consumer behavior could lead to a different future performance, she said.
