The returns on the riskiest portion of collateralized loan obligations (CLOs) are surging, reaching about 20% annualized in both Europe and the US. This boost is driven by improved loan performance, tighter debt spreads, and increased payouts. A structural feature allowing managers to add new debt to old deals has further enhanced returns for the equity slice, which is the first to take losses. CLO managers are leveraging lower funding costs to issue more lower-rated bonds and sell “deferred class F tranches,” which provide fresh distributions to equity holders.
The rally in risky debt, as recession fears wane and pricing recovers, has also been beneficial. More than a dozen such deals have been issued in Europe this year. Additionally, many CLOs exiting their non-call periods can be refinanced, restarted, or liquidated, freeing up more cash for the equity portion.
CLO equity returns have been volatile due to fluctuating arbitrage between the yields from loans and the funding costs of bonds. However, European arbitrage levels have stabilized and begun to rise slightly. In the US, equity payments have strengthened, allowing refinancings post non-call periods.
These high returns may not be sustainable. Falling interest rates or increased financial distress could reduce returns. Default rates have been lower than expected, benefiting CLO equity, but this trend might change. Investment banks are also seeking to reclaim business from direct lenders by pitching refinancings of risky private credit. Meanwhile, investors in top-rated bonds backed by commercial real estate debt are facing losses for the first time since the financial crisis, and the rise of robot investors is reshaping credit markets, challenging traditional portfolio managers.
Volta Finance Ltd (LON:VTA) is a closed-ended limited liability company registered in Guernsey. Volta’s investment objectives are to seek to preserve capital across the credit cycle and to provide a stable stream of income to its Shareholders through dividends that it expects to distribute on a quarterly basis.
