Investors have been pouring cash into a line of high-yielding exchange traded funds, but that may soon change as traders await the first interest rate cut from the Federal Reserve in more than four years. The Fed has kept its benchmark interest rate in a range of 5.25% to 5.50% since July 2023, benefiting an array of short-duration fixed income instruments, ranging from money market funds to Treasury bills. The high rates have also been a boon for collateralized loan obligations (CLOs), which are securitized pools of floating-rate loans to businesses, sometimes including non-investment grade borrowers. Income-hungry investors have been snapping up ETFs that hold these CLOs, grabbing yields that top 6% — and that can exceed 9%, depending on the ratings of the underlying CLOs. AAA-rated tranches are the least risky of these, as they are first in line to get paid if a borrower goes bankrupt. But the clock may be ticking on those high yields. “For investors, the floating rate nature – you see what’s coming down when the Fed is talking about looking at rate cuts,” said Paul Olmsted, senior manager research analyst, fixed income, at Morningstar. “That would immediately impact the [ secured overnight financing rate ], which is the benchmark for CLOs, and yields will come down at the same time,” he said. The secured overnight financing rate measures the cost of borrowing cash overnight, collateralized by Treasury securities. The pursuit of higher yields To put their popularity into perspective, Janus Henderson’s AAA CLO ETF (JAAA) has captured $6.2 billion in new money this year, and it now has roughly $12 billion in assets under management, according to FactSet. The firm’s B-BBB CLO ETF (JBBB) cracked $1 billion in AUM this summer – and with a 30-day SEC yield of 8.51%, it’s easy to see why the offering has been a hit with investors. The expectation is that once the Fed begins dialing back interest rates, yields will come down on CLOs, but gradually. “We’ve explained this to investors, that once the Fed starts cutting, there will be a lag,” said John Kerschner, head of U.S. securitized products and portfolio manager for Janus Henderson’s B-BBB CLO ETF. “It might take a year or even longer for short-end rates to get to the 4s, low 4s, high 3s.” The CLOs may also still offer attractive returns versus other fixed income asset classes, though stemming from carry – the spread they generate compared to other bonds – according to Fran Rodilosso, head of fixed income ETF portfolio management at VanEck. The firm offers the VanEck CLO ETF (CLOI) , which has a 30-day SEC yield of 6.54%. The short-duration nature of CLOs makes their prices less sensitive to fluctuations in interest rates, too – which means they also won’t experience the price appreciation longer-duration instruments will see as rates come down. “Floating rate instruments in general tend not to be capital appreciation plays, at least with regard to rate movements,” said Rodilosso. “In the current environment, in a moderate slowdown or a disinflationary environment that warrants rate cuts, the carry remains attractive.” Diversification is the theme Even when yields slip in the CLO space, they may still have a place in a diversified fixed income portfolio. For starters, if investors are legging out of money market funds, and want to generate yield on cash they may not need immediately, a CLO ETF might fit the bill, said Olmsted. “It could be that you want to be in a money market fund for up to six months [worth of cash], and if it’s six to 18 months, then something short duration,” he said. “You can look at these CLO funds, these ultrashort funds – understanding that they’re not diversified portfolios.” Indeed, a core bond fund offers investors diversification by holding Treasurys, mortgage-backed securities, asset-backed securities and corporate bonds. They also have an intermediate duration of about four to six years, meaning investors can see some price appreciation as rates come down – instead of being huddled in the short end of the curve. “Attractive yields are nice, but people are putting a lot of cash in here,” said Olmsted. “Taking a diversified approach if you like this asset class makes sense.”