CLOs: Positioning for a More Selective Market

As the macro environment continues to evolve, investors are adjusting expectations around monetary policy, inflation, and global growth. With anticipated rate cuts pushed further out, the market has been balancing mixed economic signals against a backdrop that still includes geopolitical tension and consequential U.S. midterm elections. Even so, early‑year reinvestment flows and steady demand across credit have helped anchor sentiment and maintain stability.

This stability has extended to CLOs, where institutional buyers continue to value the combination of floating‑rate coupons, structural protections, and incremental spread pickup versus other fixed income sectors. However, the picture is becoming more differentiated. Sector divergence, shifting risk sentiment, and pockets of credit pressure are contributing to greater variation in performance—reinforcing the importance of a diversified, up‑in‑quality approach.

Fundamentals: Stable, With Some Sector-Specific Risk

Fundamentals remain supported by the relative stability of the leveraged loan market, where issuers have extended maturities, preserved liquidity, and managed interest burdens reasonably well.

But the landscape isn’t uniform:

• Sector‑specific stress exists, particularly in chemicals, where oversupply concerns are elevated, and in companies exposed to competitive threats from emerging technologies.
• Downgrades and CCC migration have ticked higher, but remain concentrated rather than systemic.
• Exposure to deeply discounted loans has not meaningfully expanded, suggesting pressure remains contained.

A potential stabilizer: With expectations for rate cuts shifting further out, the prospect of lower interest burdens later in the year should help support borrower cash flows. Although idiosyncratic credit events will likely persist, broad defaults are expected to remain manageable, keeping the fundamental backdrop largely constructive.

Technicals: Strong Support, but More Dispersion

Technicals remain a source of strength for CLOs, supported by another year of elevated issuance and the typical early‑year tightening across much of the capital structure. Demand from insurers, banks, ETFs, and global wealth channels continues to reinforce the appeal of floating‑rate CLO tranches, particularly in an environment where the pace and magnitude of monetary easing remains uncertain.

But market dynamics are becoming more varied:

• Reset and refinancing activity has reshaped portfolios, as managers use these events to exit lower‑priced or credit‑challenged positions. This has amplified pressure on CCC and other weaker loans, contributing to wider performance dispersion across CLOs.
• Early-year call activity has reinforced this pattern by releasing additional stressed collateral into a segment of the market with limited natural demand—reflecting managers’ general reluctance to add lower-rated names at today’s tight spreads.
• Warehouse activity looks healthy and is elevated in both the U.S. and Europe—although managers are approaching ramping with greater selectivity given tight spreads and the inconsistent availability of new issue loan supply. While M&A‑driven issuance has lagged expectations, expectations are for more activity later in the year, which should help with CLO formation.

The result: solid support for the asset class, but a more varied landscape that rewards selectivity and manager discipline.

Opportunities Across the Capital Structure

Senior Tranches

The top of the capital structure continues to offer some of the most attractive relative value in the market, with AAA and AA tranches benefitting from:

• Durable demand
• Compelling carry
• Robust structural protections

Their liquidity profile—reinforced by an active secondary market—can also provide investors with flexibility during periods of volatility. Even with spreads sitting near recent tights, these tranches remain well positioned for modest repricing without sacrificing defensive attributes, making them a natural anchor for portfolios in a more selective market.

Mezzanine Tranches

Opportunities in mezzanine tranches are more nuanced but remain compelling for investors seeking incremental return.

• S. single‑A and BBB tranches continue to provide meaningful spread pickup for those comfortable with moderate credit risk and greater dispersion.
• European AA and A tranches present strong relative value, supported by in part by rising institutional and wealth fund participation and favorable cross‑currency dynamics that amplify the spread advantage over their U.S. counterparts.
• BB tranches can deliver attractive returns—especially in Europe—but today’s environment of rising idiosyncratic risk and increased pressure on lower‑rated loans places a premium on credit selection, manager skill and structural safeguards 

Equity: A Longer‑Term Proposition

CLO equity remains challenged by tight loan spreads, elevated downgrade activity, and a tougher arbitrage environment. However, multi‑deal platforms—particularly those able to secure favorable liability costs or deploy capital during periods of loan spread widening—can still capture attractive long‑term value.

Innovation: Broadening the CLO Opportunity Set

A growing area of opportunity also lies in the expanding universe of CLO structures beyond traditional broadly syndicated loans.

• Middle‑Market / Private Credit CLOs—once a niche area—continuing to gain traction in both the U.S. and Europe, where reinvesting and multicurrency structures are creating fresh opportunities. These deals offer exposure to less‑trafficked private credit loans with potentially higher spreads and elevated structural protections, while maintaining the familiar CLO format.
• Infrastructure CLOs are another emerging frontier. Backed by senior loans tied to essential assets—including data centers, energy infrastructure, and transportation networks—they provide access to high‑quality, long‑dated cash flows through a familiar, tranche‑based structure.

These segments remain smaller but are growing quickly, offering investors access to diversified pools of high-quality assets with long-term growth drivers at the risk and return profile of their preference.

Selectivity Will Define 2026

The CLO market enters the year balancing tight valuations, broad fundamental stability, and technical conditions that continue to evolve. With spreads near recent tights and underlying loan performance showing greater dispersion, investors face a landscape where careful credit assessment, sector awareness, and thoughtful positioning take on heightened importance.

At the same time, several anchors continue to reinforce the asset class’s durability:

• Expectations for rate cuts later in the year
• A favorable maturity profile across leveraged loans
• Steady demand across insurers, banks, ETFs and global wealth channels

The bottom line: While volatility and further dispersion are likely, compelling opportunities remain—particularly across senior and select mezzanine tranches. In this more selective market, disciplined credit work and proactive oversight become essential. Investors and managers who can navigate dispersion and position portfolios with precision will be well placed to take advantage of opportunities as they emerge.

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