Collateralised loan obligations (CLOs) have continued their positive trend as high interest rates and the potential for additional yield attract investors. Supported by a favourable economic environment, CLO performance has been strong across the capital structure. In the second quarter, AAA, AA, and single-A CLOs returned 1.77%, 2.03%, and 2.32%, respectively, while BBB, BB, and single-B CLOs saw returns of 2.94%, 4.52%, and 9.50%. Despite potential market volatility from political or geopolitical tensions, CLOs are well-positioned.
The CLO market is underpinned by strong technical forces, mainly driven by high demand across the capital structure. AAA buyers, particularly from U.S. and Japanese banks, insurance companies, and asset managers, have shown a continued appetite for risk assets. Increased inflows into AAA CLO exchange-traded funds (ETFs) reflect this trend, although this may change as the U.S. Federal Reserve’s direction on rate cuts becomes clearer. Additionally, principal repayments from amortisations have accelerated, boosting demand for AAA tranches. Mezzanine tranches benefit from elevated coupons due to the high-rate environment, providing significant funds to reinvest in the market.
New issuance in the CLO market remains subdued, exacerbated by weak new issuance in the loan market amid sluggish M&A activity. However, refinancing and reset activity has increased as managers leverage strong market conditions, with refinancing activity outpacing new issuance by a ratio of 2:1 in June. This trend is expected to continue, supported by robust demand and limited new issuance, which will likely maintain spread support and provide room for further tightening, especially in AAA tranches.
Concerns about a potential wave of defaults due to the higher-for-longer rate environment have not materialised. While the U.S. loan default rate has risen slightly, it is not expected to exceed historical averages of 3-5%. Most defaults this year have been idiosyncratic and often involved distressed debt exchanges rather than formal bankruptcies. Some borrowers facing significant challenges have engaged in liability management exercises (LMEs) to restructure their debt proactively. These exercises tend to lead to better outcomes for CLO managers, although they can impact recovery rates, which are expected to be lower this cycle than the historical average of around 70%.
Concerns about the proportion of CCC issuers in CLO portfolios persist, but this is not seen as a major issue. Managers have been conservative in managing their CCC allocations and have the ability to trade around defaults and losses. CLOs also have robust structural protections that provide additional credit support during stress periods.
Opportunities across the CLO capital structure continue to emerge, but there is a preference for quality and liquidity. Credit performance remains strong, with spreads tightening across fixed income asset classes. Most CLO tranches are trading close to par, making it less attractive to take on additional risk at this time. AAA-rated CLOs, in particular, offer attractive risk-adjusted returns. In the mezzanine sector, there is relative value in new issues from liquid, well-performing managers and select opportunities in high-quality refinancings and resets with limited tail risk exposure. CLO equity remains appealing due to tighter liability pricing and attractive arbitrage for new issue equity.
Looking ahead, CLOs stand out in credit markets due to their floating-rate nature, robust structural protections, and attractive incremental yield potential compared to other fixed income asset classes. However, with risks such as the U.S. presidential election and rising geopolitical tensions, a disciplined approach and careful selection of credits and managers will be crucial for identifying the right opportunities.
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.
