Bets on Risky CLOs Yield 20% Annualized Returns: Credit Weekly

Key Takeaway

• Riskiest CLO equity slices are yielding 20% annualized returns due to improved loan performance and tighter debt spreads.
• Managers are boosting returns by issuing deferred class F tranches, benefiting from falling funding costs and strong risky debt rally.
• Future CLO equity returns may decline if central banks cut interest rates or financial distress increases.

CLO Equity Returns Surge

Returns on the riskiest portion of collateralized loan obligations (CLOs) have surged, reaching approximately 20% annualized on both sides of the Atlantic. This impressive performance is driven by improved loan performance, tightening debt spreads, and growing payouts. A structural quirk has also played a role, allowing managers to add fresh debt to older deals, thereby boosting returns to the equity slice, which is the first piece of the structure to take losses. James Baillie, a structured credit partner at Paul Hastings in London, noted, "Managers are able to flush the sale proceeds straight out to equity, which can lead to bumper returns."

Deferred Tranches and Refinancing

The issuance of "deferred class F tranches" has been a significant factor in the recent performance of CLOs. These tranches are added to older CLOs, and the proceeds from their sale are distributed to equity holders, enhancing returns. This strategy has been employed by several CLO managers, including Invesco and Capital Four, particularly in Europe. Additionally, many CLOs have exited their non-call periods, allowing them to be refinanced, restarted, or liquidated. This process frees up more cash for equity holders. Baillie explained, "In both approaches you’re moving from a less levered to a more levered position and that’s giving you in some instances an equity dividend."

Stabilized Arbitrage Levels

CLO equity returns have been volatile in recent years due to fluctuating arbitrage levels—the difference between the yields a manager earns from the loans it buys and the funding costs on the bonds it issues. After a decline in 2023, European arbitrage levels have stabilized at around 200 basis points and have recently started to rise marginally. Ben Hunsaker, a portfolio manager at Beach Point Capital Management, commented on the US market, stating, "In 2022 and 2023, spreads were wider on both assets and liabilities which made placing third party CLO equity more challenging." He added that these deals have likely experienced strong equity payments and should be able to refinance their liabilities when their non-call periods end.

Street Views

• James Baillie, Paul Hastings (Bullish on CLO equity):

  "Managers are able to flush the sale proceeds straight out to equity, which can lead to bumper returns."

• Ben Hunsaker, Beach Point Capital Management (Cautiously Optimistic on US CLO market):

  "In 2022 and 2023, spreads were wider on both assets and liabilities which made placing third party CLO equity more challenging. Those deals have likely since experienced strong equity payments and should be able to refinance their liabilities when their non-call periods end."

• Dan Ko, Eagle Point Credit Management (Neutral on CLO defaults):

  "The market was pricing in 3% to 4% defaults last year and 4% to 6% defaults this year, but we’ve observed materially less defaults in CLO portfolios, which has benefited CLO equity."