CLOser to the mark

The Fed is not hiking rates in response to a transitory fuel price shock. They’re recalibrating policy to “ensure that credit and financial conditions are consistent” with their price stability objective. The focus is not higher overnight interest rates per se, but the transmission of healthier cash returns to bond yields, stock markets, exchange rates, and credit spreads.

For the prior two years, the Fed maintained a conditional easing bias, encouraging investors to expect that rate cuts would arrive without any deterioration in economic activity (see Appendix A below). This guidance suppressed forward interest rates (Figure 1), anchored bond yields at artificially low levels, and encouraged market participants to step out further on the risk spectrum. No surprise that core inflation never returned to target; the Fed’s own rhetoric undermined the tightening of financial conditions necessary to contain it (A monetary lapse of reason).

Figure 1: Until May, Fed guidance suppressed forward interest rates

By dispensing with the fiction that monetary policy remained “restrictive”,¹ and that short-term interest rates would eventually settle at or below 3% once policymakers saw “additional progress” on inflation, the Warsh Fed triggered a repricing in bond markets, sharp rise in the foreign exchange value of the dollar, and broader reassessment of portfolio positioning. Corporate credit looks to be the next asset class to reprice. With 12-month forward SOFR above 4.5% and two-year Treasuries periodically yielding nearly 5%, investors may need more enticement to assume credit risk.

While the Fed was guiding towards rate cuts, credit spreads fell to levels not seen since the spring of 2007 (Figure 2). By September 2026, the median weighted-average spread on broadly syndicated loans held in US collateralized loan obligations (CLOs) fell below 300 basis points – the tightest level in more than a decade. Even more remarkable was the narrow band around this median, with spreads on the highest-yielding CLOs in September 2026 tighter than those of the lowest-yielding CLOs over the past decade.

Figure 2: Massive compression in credit spreads in conditional easing era

There have been some notable instances of spread widening in October, but that’s been largely confined to interest rate-sensitive businesses and AI data center build out fears (Figure 3). Expect that to broaden from here. As of September 2026, one-in-seven loans held in CLOs are both performing (i.e. priced above $90 per $100 of par) and set to mature before the end of 2029. The last time performing loan refinancing needs reached these levels (2022), average weighted spreads widened to 374bps the following year. With one-third of such loans concentrated in sectors, like software, thought to face AI disintermediation risk (The future is not what it used to be), similar widening may be in store for 2027 as these borrowers come to terms with the erosion in their bargaining power.

Figure 3: Repricing observed across AI credits likely to broaden

At the same time, heightened interest rate risk and bond market volatility make floating CLO liabilities an especially attractive alternative to duration. AAA CLO liabilities currently yield roughly 120bps more than SOFR. To earn roughly the same yield in the Treasury market, investors must assume the interest rate risk associated with lending at fixed rates far into the future. The 10-year (124bps above cash yields) and 30-year (156bps) Treasury bonds yield slightly more than the AAA tranches of CLO liabilities but in exchange for annualized volatility that’s between 8x to 16x greater. Maybe this trade made sense when Treasury bonds “hedged” stock market risk – predictably rising in value when stocks sold off – but that hasn’t been the case in over four years (Figure 4). Today, bonds are likely to lose value at the same time as stocks.

Figure 4: CLO liabilities attractive alternative to Treasury volatility

Whether or not the Fed proves bold enough to raise rates the week before the midterm election, the direction of travel is clear: tighter financial conditions. This has many investors on edge, but what’s scary about normalization in the pricing of interest rate and credit risk? Expected returns increase as base rates and the price of risk rise. And this moment looks especially propitious for CLO investors, as spreads on loan assets reprice wider and interest rate risk increases the demand for zero effective duration CLO liabilities as an alternative to the sharp and unsettling moves in the Treasury market.

Appendix A: 64 instances where Fed officials guided towards rate cuts, absent any weakening in economic activity, if they observe “progress” on inflation

1 For the perils of relying on an unobservable neutral rate to guide policy, see “Are Policy Rates Restrictive?” January 2025.