No one knows exactly when the Federal Reserve will decide to increase its benchmark lending rate, but we do know that it will inevitably happen.
Participants in a recent panel discussion on Collateralized Market Obligation (CLO) trends and investment opportunities shared their perspectives on how a rise in the Federal Reserve Rate may affect the asset class as a whole. Here are some highlights:
The Impact Of Fed Rate Increases
- The Debate Continues: Panelists indicated that we will likely see the beginning of rate increases in 2015; however they disagreed on the direct impact to the CLO markets.
- Hedging As The Linchpin: If investors are hedging against the implications of a rising Fed Rate, panelists described the ability to avoid potential fallout. Employing LIBOR floor hedges, for example, could help investors in managing exposures.
- Unleveraged Loan Portfolios May Become More Attractive Than CLOs: With an expected increase in interest rates, panelists anticipate that investors may buy unleveraged loans via separately managed accounts rather than CLOs, which may see some arbitrage erosion as a result of LIBOR floors. If and when this occurs, panelists anticipate an increase in the perceived attractiveness of unleveraged loan investments (as opposed to CLOs).
- More Risks & Challenges: Panelists cite the fact that higher interest rates will pose a number of challenges for equity investors as arbitrage opportunities are squeezed, and collateral yields remain the same. Moreover, the potential tightening of AAA spreads will also threaten re-pricing as an option, and could run into risk retention rules, posing even more challenges for CLO issues.
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