This lucrative investment might lose its appeal if interest rates decrease.

Investors have been heavily investing in high-yield exchange-traded funds (ETFs), but this trend might shift as traders anticipate the Federal Reserve’s first interest rate cut in over four years. Since July 2023, the Fed has maintained its benchmark interest rate between 5.25% and 5.50%, which has favored short-term fixed income assets like money market funds and Treasury bills. These high rates have also benefited collateralized loan obligations (CLOs), which are pools of floating-rate loans to businesses, including some non-investment grade borrowers. Investors seeking higher returns have been flocking to ETFs that hold these CLOs, with yields ranging from over 6% to more than 9%, depending on the CLOs’ ratings. The safest of these, AAA-rated tranches, are prioritized for payment if a borrower defaults. However, these high yields may not last. Paul Olmsted, a senior manager research analyst at Morningstar, noted that the floating rate nature of CLOs means their yields will decrease when the Fed starts cutting rates. The secured overnight financing rate, which benchmarks CLOs, will also drop, impacting yields.

To illustrate the popularity of these investments, Janus Henderson’s AAA CLO ETF (JAAA) has attracted $6.2 billion in new investments this year, bringing its total assets to around $12 billion. The firm’s B-BBB CLO ETF (JBBB) reached $1 billion in assets this summer, boasting a 30-day SEC yield of 8.51%. John Kerschner, head of U.S. securitized products at Janus Henderson, explained that while yields on CLOs will decline once the Fed cuts rates, this will happen gradually, potentially taking a year or more for short-term rates to fall to the low 4% or high 3% range. Despite this, CLOs may still offer competitive returns compared to other fixed income assets due to the spread they generate, according to Fran Rodilosso, head of fixed income ETF portfolio management at VanEck. VanEck’s CLO ETF (CLOI) has a 30-day SEC yield of 6.54%. The short-term nature of CLOs makes their prices less sensitive to interest rate changes, meaning they won’t see the same price appreciation as longer-term instruments when rates drop. Rodilosso noted that floating rate instruments generally don’t benefit from capital appreciation due to rate movements, but they remain attractive in a moderate slowdown or disinflationary environment that justifies rate cuts.

Even as CLO yields decline, they can still play a role in a diversified fixed income portfolio. For investors moving out of money market funds and looking to earn yield on cash they don’t need immediately, a CLO ETF could be suitable, according to Olmsted. He suggested that money market funds might be appropriate for cash needed within six months, while CLO funds could be considered for cash needed in six to 18 months, though they are not as diversified. Core bond funds, which include Treasurys, mortgage-backed securities, asset-backed securities, and corporate bonds, offer more diversification and have an intermediate duration of about four to six years, allowing for some price appreciation as rates fall. Olmsted emphasized the importance of a diversified approach for those interested in this asset class, given the significant cash inflows.