Collateralized loan obligation (CLO) professionals anticipate an active, but subdued, market throughout the rest of the year. A wide range of trends and events, however, could change that outlook.
The U.S. CLO market issued $290 million by early August. That's nothing to sneeze at, said Sean Griffin, CEO and executive director of the LSTA, but it was down 12% compared to the same period last year and is unlikely to approach the record volumes of the last two years.
Griffin noted that leveraged loans outstanding stood at $540 billion by early August, down 24% year-over-year. Lower supply levels coupled with heightened demand for floating-rate paper has squeezed loan spreads and CLO returns. Meanwhile, the spreads on the liabilities CLOs pay to investors, hovering around 120 basis points for AAA bonds, have yet to rally as much as loan spreads.
"Spread compression on the leveraged loan side has made the arbitrage more challenging," Griffin said.
Conditions work for some
CLO managers with a captive rather than third-party equity are more apt to approach the market. Currently in the market with its second CLO after pricing its inaugural $507 million transaction in March, Mountain Point Credit Management may seek to complete another one this year, depending on market conditions, said Kelly Byrne, CEO of the CLO manager. Mountain Point's majority owner, Eagle Point Holding, has agreed to provide equity support for its next few deals.
"My expectation is we'll see an active market in September and October and it will start to slow in November, as it has historically," Byrne said, "Assuming there's no major pick up in volatility for one reason or another."
Should volatility increase, however, "That would be great for the CLO market," Byrne said, since it would likely widen spreads on leveraged loans and improve the arbitrage.
"A big volatility spike could slow new CLO creation, but it could give CLO managers the opportunity to build par," Byrne said, by opportunistically acquiring loans whose prices were inappropriately pushed down.
Widening loan spreads could also result in more "print and sprint" deals, at least while liability spreads lag, Griffin said, where CLO managers lock in their liabilities and funding costs before buying the loan assets, rather than purchasing most of the loans first. He also anticipates fewer CLO resets, since 2024 deals exiting their noncall provisions this year were priced at spreads similar to today's, providing little rate benefit while incurring advisory and other reset costs.
We'll see an active market in September and October and it will start to slow in November.
In addition, credit concerns in sectors such as software could provide a further hurdle, Griffin said, since some portfolios may have to sell problematic loans and require equity contributions for a reset to make sense.
Instead, Griffin said, CLO managers may choose to refinance deals if they can get a more attractive interest rate.
The roles of rates and software
The direction of interest rates will be another key factor impacting CLOs. Should they remain high or even increase, investor demand for floating-rate CLOs may grow. However, the advent of artificial intelligence and other factors could also exacerbate some companies' already growing credit challenges and potentially impact CLO equity.
John Kerschner, global head of securitized products at Janus Henderson Investors, which manages ETFs that invest in CLOs' AAA and BBB tranches, noted that software companies make up 14% of the portfolios of CLOs investing in broadly syndicated loans. They faced numerous downgrades earlier this year, fueled by concerns about the impact of AI on their business models. However, even if half the companies were to default, investor protections structured into deals make it unlikely that rated tranches would be impacted.
When loan spreads are compressing, CLO liabilities haven't compressed as much, and CLO investors start to feel a bit more concerned about credit risk.
"It's more downgrade risk," Kerschner said, when the ratings agencies' models prompt ratings downgrades or negative outlooks across a slew of companies' debt. He added that sectors to monitor in addition to software are housing, if rates remain high, and healthcare.
Griffin said that tight arbitrage has already prompted some investors in CLO equity to shift their portfolios toward rated CLO debt where they're finding more attractive yields and less risk.
"We've seen that before, when loan spreads are compressing, CLO liabilities haven't compressed as much, and CLO investors start to feel a bit more concerned about credit risk," he said.
He pointed to research reports noting credit concerns have also prompted CLOs to move away from CCC-tranche paper, likely at a loss, into single B credits, a trend that could increase sales of BB loans.
"You may sell your BBs that are trading at higher prices than where you bought them to generate additional cash so you're not burning through as much par when you sell riskier assets from a credit perspective at a loss," he said.
Forex factors
Another factor to monitor in the months ahead, Griffin said, is the weakening yen against the U.S. dollar. A weaker yen makes it more expensive for Japanese banks to invest in CLO AAAs, lessening their incentives to invest in that market in which they've been major players for years.
In addition, the National Association of Insurance Commissioners (NAIC) is revising capital charges for investing in CLOs, set to go into effect at the start of 2027. Although it is still deliberating, Griffin said, the charges are likely to decrease significantly for tranches rated single-A or higher and increase for lower-rated tranches.
