Collateralised loan obligations (CLOs) have maintained their positive performance, as higher interest rates and the potential for incremental yield continue to attract investors. Supported by a favourable economic backdrop, CLO performance has remained solid across the capital structure. During the second quarter, returns were notable, with AAA, AA, and single-A CLOs posting returns of 1.77%, 2.03%, and 2.32% respectively. Meanwhile, the riskier BBB, BB, and single-B CLOs delivered even higher returns of 2.94%, 4.52%, and 9.50%. Although market volatility could resurface in the months ahead due to political uncertainty, geopolitical tensions, or other factors, CLOs remain well-positioned in the current environment.
Investor demand continues to drive the strength of the CLO market, particularly among AAA buyers who have shown renewed interest in risk assets. This demand has been led by U.S. and Japanese banks, alongside insurance companies and asset managers, with AAA CLO exchange-traded funds (ETFs) also seeing inflows. As the U.S. Federal Reserve’s intentions regarding rate cuts become clearer, this dynamic may shift. Principal repayments from amortisations have increased, further boosting demand for AAA tranches, while mezzanine tranches benefit from elevated coupons in the high-rate environment, contributing to a favourable technical backdrop.
In terms of new issuance, activity has remained muted, hindered by limited issuance in the loan market as mergers and acquisitions (M&A) remain sluggish. However, refinancing and reset activity has gained momentum, as managers seek to take advantage of the strong market conditions. In June, refinancing outpaced new issuance by a ratio of 2:1. Looking ahead, the combination of robust demand and limited new issuance is expected to support spreads and potentially lead to further tightening, particularly in AAA tranches.
Despite concerns about the impact of prolonged high interest rates on companies reliant on the leveraged loan market, a wave of defaults has not materialised. The default rate for U.S. loans has risen slightly but remains within historical norms of 3-5%. The defaults observed this year have largely been isolated incidents, often resolved through distressed debt exchanges rather than formal bankruptcy proceedings. Some borrowers facing significant challenges have opted to restructure their debt through liability management exercises (LMEs), which, although potentially lowering recovery rates, tend to yield better outcomes for CLO managers experienced in restructuring.
There have been some concerns about the rising proportion of CCC-rated issuers in CLO portfolios. However, managers have been conservative in managing their CCC allocations in preparation for a potential economic downturn. They also have the flexibility to trade around defaults and losses, and CLO structures offer additional credit support during times of stress, reducing the likelihood of significant market disruption.
As opportunities continue to present themselves across the CLO capital structure, a focus on quality and liquidity remains important. Credit performance has generally been strong, with spreads tightening across various fixed income asset classes, leaving most CLO tranches trading near par. Given these conditions, now may not be the time to take on additional risk. AAA-rated CLOs remain attractive due to their appealing risk-adjusted returns.
In the mezzanine portion of the market, new issues from liquid, well-performing managers continue to offer value. There are also opportunities in high-quality refinancings and resets that have limited exposure to riskier credits. These transactions are typically priced wider than pure new issues, allowing capital to be deployed sooner. CLO equity remains of interest, as tightening liability pricing makes the arbitrage for new issue equity more attractive than it has been in recent years.
Looking ahead, the strong performance of CLOs, driven by their floating-rate nature, structural protections, and incremental yield potential, positions them favourably compared to other fixed income options. Nevertheless, with risks such as the U.S. presidential election and global geopolitical tensions on the horizon, a disciplined approach will be necessary. Careful credit and manager selection, with a focus on bottom-up analysis, will be critical to identifying the best opportunities in the market going forward.
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.
