XFLT: Navigating Rising Rates with a Diversified Alternative Income Strategy

In an era where central banks have signaled a prolonged tightening cycle, income-focused investors are increasingly scrutinizing strategies that can withstand—and even benefit from—higher interest rates. The XAI Octagon Floating Rate & Alternative Income Trust (XFLT) has positioned itself as a compelling candidate in this landscape, leveraging a diversified portfolio of floating-rate credit instruments and alternative assets to generate resilient income. But does its strategy hold up under the weight of recent market volatility, and can it deliver on its promise of stability in a rising rate environment?

Strategic Positioning in a Rising Rate World

XFLT's core thesis is built on its emphasis on floating-rate assets, which adjust periodically to reflect changes in benchmark interest rates. This structure inherently insulates the fund from the price depreciation that plagues fixed-rate bonds in a tightening environment. The fund's primary allocations—senior secured loans, Collateralized Loan Obligations (CLOs), and opportunistic credit—further amplify this advantage. Senior secured loans, for instance, typically offer floating rates with spreads over LIBOR or SOFR, ensuring that income streams rise in tandem with central bank hikes. CLOs, meanwhile, are structured to prioritize senior tranches that benefit from the same floating-rate dynamics, while their equity components offer upside potential in credit cycles.

The fund's active management approach, led by Octagon Credit Investors, adds another layer of resilience. Octagon's proprietary credit selection process—rooted in fundamental analysis and relative value—enables the team to adjust allocations in real time. For example, during periods of economic uncertainty, the fund may tilt toward higher-quality senior loans, whereas in a more accommodative environment, it might increase exposure to CLO equity or distressed credits. This flexibility is critical in a rising rate world, where rigid strategies can quickly become misaligned with shifting market conditions.

Diversification as a Buffer

Diversification is not just a buzzword for XFLT—it's a structural imperative. The fund's exposure spans private credit markets, including below-investment-grade loans and structured instruments, which are less correlated with public equity and bond markets. This low correlation is particularly valuable in a rising rate environment, where traditional fixed-income assets often underperform. For instance, in 2023, while the S&P 500 rallied on the back of AI optimism, XFLT's 12.97% annual return demonstrated its ability to capitalize on credit spreads and floating-rate adjustments.

However, the fund's performance in 2022 and 2024—-29.15% and -7.00%, respectively—highlights the risks of its strategy. Rising rates can exacerbate defaults in leveraged credit markets, and XFLT's focus on private, non-investment-grade assets means it is not immune to such shocks. The fund's leverage of up to 40% of managed assets, while lower than industry averages, still introduces volatility that can amplify losses during downturns.

Income Resilience: A Double-Edged Sword

XFLT's 14.5% yield as of June 2025 is a siren song for income-starved investors. The fund's distribution policy, which has maintained monthly payouts since 2016, is a testament to its commitment to income generation. Yet, the payout ratio of 490% raises eyebrows. This suggests that distributions are being funded not just by net investment income but also by return of capital or capital gains—a practice that, while not inherently problematic, signals potential sustainability risks if market conditions deteriorate further.

The fund's ability to maintain its yield hinges on its capacity to generate consistent cash flows from its floating-rate portfolio. In a rising rate environment, this should theoretically hold true, as higher rates increase the income from loans and CLOs. However, the recent drawdown of -15.13% as of August 2025 underscores the fragility of this model when broader economic conditions, such as recessionary fears or liquidity crunches, come into play.

The Verdict: A Strategic Bet with Caveats

For investors seeking income in a rising rate world, XFLT offers a unique blend of active management, floating-rate exposure, and alternative asset diversification. Its historical performance in 2021 (18.93% return) and 2023 (12.97% return) demonstrates its potential to thrive when credit markets are resilient. However, the fund's recent struggles—particularly its inability to recover from the 2020 drawdown of -60.39%—highlight the importance of risk tolerance and time horizon.

The fund's Sharpe ratio of -0.53 over the past year is a red flag, indicating poor risk-adjusted returns. Yet, its 5-year Sharpe ratio of 0.53 suggests that, over the long term, the strategy can deliver value. Investors must weigh this against the fund's high expense ratio and the inherent risks of private credit markets.

In conclusion, XFLT is not a guaranteed winner in a rising rate environment, but it is a strategically positioned player. For those with a medium-term horizon and a tolerance for volatility, it could serve as a complementary piece of a diversified income portfolio. However, it is not a substitute for a robust risk management framework or a diversified credit strategy. As always, the key lies in aligning the fund's characteristics with one's own financial goals and market outlook.