While AAA-rated collateralized loan obligations (CLOs) performed well for risk-averse investors from 2022 to 2024, Angel Oak believes that recent market developments suggest a pivot to lock in higher yields and diversify short-duration allocations. The Federal Reserve is projecting that monetary policy will result in lower short rates (Figure 1), while recent geopolitical uncertainty has also increased the probability of an economic slowdown. This would create a two-pronged stressed scenario for AAA CLOs — diminished floating-rate coupons and lower income paired with potential spread widening and accompanying price depreciation.
Figure 1: FOMC Summary of Economic Projections
Source: Federal Reserve as of 3/19/25.
Last year, flows into ETFs were a significant driver of demand for AAArated CLO tranches as investors sought fixed-income strategies that performed well during the rate rise of 2022 and 2023. Looking for a yield enhancement over 5-year Treasuries, they increasingly turned to ETFs offering exposure to high-quality CLO tranches. This surge in demand led to substantial outperformance for this 5-year floating-rate sector, but it limits the opportunity set in 2025.
The current levels of geopolitical uncertainty and associated market volatility have increased the probability of economic turbulence. This could cause outflows from investors rotating back into money market funds, a development that may result in spread normalization for AAA CLOs. In fact, spreads for this asset class have already widened from 112 basis points at January month-end to 130 basis points as of 3/14/25, an 18-basis point increase.1
CLOs tend to be floating rate, whereas other elements of the securitized credit market tend to be fixed rate. Floating-rate securities will not appreciate as much if short rates decline, while widening spreads can result in substantial price deterioration due to spread duration (Figure 2).
Figure 2: Scenario Analysis of Diversified Portfolio of AAA-Rated CLOs
Source: Angel Oak internal analysis from publicly available data as of 3/21/25.
We believe investors should consider diversifying away from a concentration in floating-rate AAA-rated CLOs and into investment-grade fixed-rate securitized assets with substantial credit enhancement that could benefit from declining rates.
1Source: Bank of America Historical Spreads Report as of 3/21/25.
DEFINITIONS AND DISCLOSURES
Agency Mortgage-Backed Securities (AMBS): Securities issued or guaranteed by the U.S. government or a GSE.
Basis Point (bps): One hundredth of one percent and is used to denote the percentage change in a financial instrument.
Bloomberg U.S. Corporate Investment Grade Index: An index that measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers.
Collateralized Loan Obligation (CLO): A single security backed by a pool of debt.
Current Coupon: Refers to a security that is trading closest to its par value without going over par. In other words, the bond’s market price is at or near to its issued face value.
Duration: Measures a portfolio’s sensitivity to changes in interest rates. Generally, the longer the duration, the greater the price change relative to interest rate movements.
Federal Funds Target Rate: A target interest rate set by the central bank in its efforts to influence short-term interest rates as part of its monetary policy strategy.
Floating Rate: A floating-rate security is an investment with interest payments that float or adjust periodically based upon a predetermined benchmark.
FOMC Dot Plot: A chart summarizing the Federal Open Market Committee’s outlook for the federal funds rate. Each dot marks where a respective FOMC member expects the federal funds rate to be at the end of a particular period
Secured Overnight Financing Rate (SOFR): A broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities.
Spread: The difference in yield between a U.S. Treasury bond and a debt security with the same maturity but of lesser quality.
Weighted Average Life (WAL): Average length of time that each dollar of unpaid principal on a loan, a mortgage or an amortizing bond remains outstanding
Yield Curve: The U.S. Treasury yield curve refers to a line chart that depicts the yields of short-term Treasury bills compared to the yields of long-term Treasury notes and bonds.
Opinions expressed are as of 3/31/25 and are subject to change at any time, are not guaranteed, and should not be considered investment advice.
Investing involves risk; principal loss is possible. Investments in debt securities typically decrease when interest rates rise. This risk is usually greater for longer-term debt securities. Investments in lower-rated and nonrated securities present a greater risk of loss to principal and interest than do higher-rated securities. Investments in asset-backed and mortgage-backed securities include additional risks that investors should be aware of, including credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. Derivatives involve risks different from — and in certain cases, greater than — the risks presented by more traditional investments. Derivatives may involve certain costs and risks such as illiquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lead to losses that are greater than the amount invested. The Fund may make short sales of securities, which involves the risk that losses may exceed the original amount invested. The Fund may use leverage, which may exaggerate the effect of any increase or decrease in the value of securities in the Fund’s portfolio or the Fund’s net asset value, and therefore may increase the volatility of the Fund. Investments in foreign securities involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks are increased for emerging markets. Investments in fixed-income instruments typically decrease in value when interest rates rise. The Fund will incur higher and duplicative costs when it invests in mutual funds, ETFs and other investment companies. There is also the risk that the Fund may suffer losses due to the investment practices of the underlying funds. For more information on these risks and other risks of the Fund, please see the Prospectus.
ETFs may trade at a premium or discount to NAV. Shares of any ETF are bought and sold at market prices (not NAV) and are not individually redeemed from the Fund. Brokerage commissions will reduce returns.
Investors should carefully consider the investment objectives, risks, charges and expenses of the Angel Oak Funds. This and other important information about each Fund is contained in the Prospectus or Summary Prospectus for each Fund, which can be obtained by calling 855-751-4324 or by visiting www.angeloakcapital.com. The Prospectus or Summary Prospectus should be read carefully before investing.
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