CLOs: A Bias for Quality & Liquidity

After a strong start to the year, collateralized loan obligations (CLOs) have felt the full effects of the volatility stemming from the Trump administration’s tariff announcements. In the immediate aftermath, amid concerns over the potential impact on growth, inflation and confidence, CLO spreads widened across the capital structure and primary markets came to a halt. At the same time, secondary markets experienced increased selling pressure, with ETF outflows becoming increasing prevalent as market participants looked to raise cash in anticipation of further volatility.

Sentiment has since improved following the suspension of most tariffs for 90 days, but uncertainty remains high, with markets likely to continue reacting to policy news out of the White House. In environments like this, in which technicals tend to overwhelm fundamentals, high-conviction views are challenging to come by. Generally speaking, we see merits to staying up in quality and liquidity. But volatility can, and often does, lead to opportunities as well—and there are reasons to believe that attractive entry points will emerge going forward.

Fundamentals & Technicals

From a fundamental perspective, credit concerns and default risks have been a focal point amid the tariff-induced volatility. From a credit standpoint, it’s too early to tell what the full effects of Trump’s tariffs will be. On the positive side, loan fundamentals are starting from very healthy levels given than many issuers have taken steps to shore up their balance sheets in recent years. There also has been no significant uptick in the U.S. loan default rate, and we do not believe it will exceed 2% to 3% this year. While issuers in sectors directly impacted by tariffs present a greater concern, the impact is likely to be nuanced.

Second-order concerns also have materialized around the proportion of CCC issuers in CLO portfolios, and whether that may be set to increase. However, we don’t believe this will create a major issue for the market, as many managers have been more conservative in managing their CCC allocations over the last several years. It is also worth noting that CLOs have weathered past periods of volatility and stress relatively well. CLO structures are notably robust, partially because they contain a series of features—namely subordination, overcollateralization tests and interest diversion tests—that protect investors’ capital over the life of a deal. As a result, even if the backdrop deteriorates going forward and fundamentals become more stressed, we would not expect defaults to exceed the stress capacity that CLO structures were built to withstand.

Looking Across the Capital Structure

If we assume that worst-case scenarios don’t play out—such as a spike in inflation followed by a material increase in rates—we believe a likely outcome is that CLOs will move within a range in the coming quarters as opportunistic sellers exit positions into strength, and weakness is met by investors looking to put fresh capital to work and capitalize on dislocations. That said, given the likelihood of continued volatility, our bias for the time being remains toward quality and liquidity. Risk-remote AAA and AA tranches, for instance, continue to look attractive given their position at the top of the capital structure and high potential carry on offer. In the mezzanine part of the capital structure, we continue to look for opportunities in high-quality secondary tranches that offer greater discount but have limited exposure to risky credits. Going forward, there may also be a case to make for clean, new issue deals that have less exposure to tariff-impacted sectors.

CLO equity also remains interesting, although the opportunity is more nuanced given that the primary market is still in a price discovery environment. If loan prices trade off going forward, we may see an increase in new issue “print and sprint” deals, where managers accumulate assets and ramp portfolios quickly, often over a few days, in the secondary loan market at discounted levels. Often, print-and-sprint deals are structured with shorter, one-year non-call periods—and the option to call the deal opportunistically after only one year is potentially quite valuable and can translate into attractive returns from an equity perspective, even amid wider initial debt tranche spreads.

Regulatory Updates

While (almost) all eyes are on policy updates, there are a number of potential regulatory changes on the horizon that could impact the market going forward as well. A proposed amendment to Basel III aims to reduce the risk-weighted asset requirement for AAA CLO tranches from 20% to 15%. In making it more attractive for U.S. banks to invest in these CLOs, the proposed change, by some estimates, could result in up to $190 billion of new capital entering the market. Concurrently, the NAIC is reassessing capital charge factors for certain asset classes, including CLOs, which could boost demand for AAA, AA, and single-A CLO tranches. In Europe, regulators are also scrutinizing risk retention compliance, with guidelines released recently that may ultimately affect managers issuing new deals in the region.

Conclusion

As the Trump administration continues to roll out its policies, particularly those around trade, we expect the market to experience further bouts of volatility. Against this backdrop, it’s worth noting that periods of volatility can, and often have, led to price dislocations, during which even higher-quality portions of the capital structure are marked down, in some cases to prices well below what fundamentals would suggest. Given CLOs’ inherently strong structural protections and low historical default rates, these periods of stress can often also lead to compelling investment opportunities. However, active management and careful manager selection will be crucial to uncovering the best absolute and relative value up and down the capital structure, while also seeking to avoid unwanted risks.