XFLT: Economic Bifurcation Bleeds CLO Equity

The global economy is increasingly marked by bifurcation: while some sectors thrive under accommodative monetary policies, others face relentless pressure from rising interest rates and compressed credit spreads. For income-focused investors, the Collateralized Loan Obligation (CLO) equity market—once a haven for high yields—has become a battleground of competing forces. At the heart of this tension lies the XAI Octagon Floating Rate & Alternative Income Trust (XFLT), a closed-end fund that has long positioned itself as a resilient player in the structured credit space. Yet, as spreads tighten and rate volatility intensifies, XFLT's ability to sustain its 15% yield is being tested.

The CLO Equity Conundrum

CLO equity, the residual claim in a CLO structure, has historically offered attractive returns by capturing the spread between loan collateral and liability costs. However, 2025 has seen a dramatic compression of these spreads. Loan collateral spreads now sit at the 10th percentile historically, while CLO liability spreads have tightened to near-historic lows. This has eroded the arbitrage that underpins CLO equity returns. For example, the median equity distribution for reinvesting CLOs has fallen from 4.0% in July 2024 to an estimated 3.2% in April 2025.

The result is a bifurcation within the CLO market itself. While CLO debt remains relatively stable, equity tranches face a dual threat: declining income from tighter spreads and heightened sensitivity to defaults. For XFLT, which allocates up to 20% of its assets to CLO equity, this dynamic has reduced distribution coverage to 90%—a stark contrast to its historical ability to sustain high yields.

XFLT's Strategic Resilience

XFLT's investment thesis hinges on its focus on floating-rate instruments and active portfolio management. Managed by Octagon, a firm with over 25 years of credit expertise, the fund employs a disciplined approach to risk. Its portfolio is dynamically adjusted based on proprietary credit evaluations, liquidity assessments, and collateral quality. This agility has allowed XFLT to navigate the current environment with a mix of caution and opportunism.

One key strategy is leveraging CLO resets and refinancing. As liability spreads tighten, Octagon has prioritized transactions that lock in low financing costs, extending reinvestment periods to capitalize on future volatility. For instance, prior to resets, CLO managers have sold higher-priced CCC loans to reduce risk, while using equity capital injections to rebuild loss reserves. This proactive approach mitigates the drag on distributions caused by spread compression.

Octagon's team, including Investment Committee members like Lauren Law and Michael Nechamkin, has also emphasized credit selection. By rotating out of overvalued BB-rated loans and executing risk-reduction trades, the firm aims to preserve capital during periods of heightened volatility. This is particularly relevant in a market where macroeconomic uncertainties—such as Trump-era tariff policies—could exacerbate sector-specific risks.

The Discount to NAV: A Double-Edged Sword

XFLT currently trades at a 7.96% discount to its net asset value (NAV), a level some analysts view as attractive. Historically, discounts in CLO-focused CEFs often reflect market sentiment rather than intrinsic value. For XFLT, the discount may offer a margin of safety, especially if its active management strategies prove effective in stabilizing yields. However, the discount also highlights investor skepticism about the fund's ability to maintain its high yield in a low-spread environment.

The fund's leverage—39.13% as of August 2025—adds another layer of complexity. While leverage can amplify returns, it also increases sensitivity to interest rate hikes and liquidity shocks. Octagon's conservative risk controls, including a four-step investment process and rigorous collateral analysis, are critical in mitigating these risks.

Is XFLT Still a Compelling Bet?

The answer depends on the investor's risk tolerance and time horizon. For those seeking immediate income, XFLT's 13.93% annualized distribution rate remains compelling. However, the sustainability of this yield is contingent on Octagon's ability to navigate the current bifurcation. The firm's active management strategies—particularly its focus on CLO resets and collateral quality—offer a path to resilience.

Yet, the broader economic landscape remains fraught. If spread compression persists or defaults rise, even XFLT's disciplined approach may struggle to offset losses. Investors should also consider the fund's exposure to secondary market liquidity risks, where ETF-driven volatility could further pressure its discount.

Conclusion: A Calculated Gamble

XFLT embodies the duality of today's credit markets: a high-yield opportunity shadowed by structural headwinds. Its appeal lies in Octagon's proactive risk management and the inherent optionality of CLO equity. However, the fund's success will ultimately depend on the interplay of macroeconomic forces—particularly the trajectory of interest rates and the resilience of loan collateral.

For investors willing to accept the risks of a volatile environment, XFLT remains a compelling alternative to traditional fixed-income assets. But patience and a long-term perspective are essential. In a world of economic bifurcation, the key to unlocking value lies not in chasing yields, but in navigating the cracks between them.