1. Tightening triple-As

Triple-A US CLO spreads have tightened a fair amount in recent months. At the start of 2024, spreads were around SOFR+165bps, but a S+125bps print was recently announced. This tightening trend is expected to continue into 2025, with market participants predicting a further reduction of 15-20bps, bringing spreads to around S+110-120bps.

Panelists across multiple discussions were in general agreement that triple-As have substantial room to tighten further.

“Everything aside from the triple-As is printing at or near historical tights, and there’s no doubt that triple-As have significant room to run,” one panellist said. “I think a lot of that has to do with the fact that we’ve spent a year all being ridiculously exhausted via these refinancing transactions that are starting significantly wide, everything is approved when you're starting from S+180bps.”

2. Loan volume predictions split market

As we look ahead to 2025, a key question dominating the conversation is whether a viable loan market will emerge that can sustain the CLO machine.

Both US CLOs and leveraged loans have seen robust activity in 2024, characterised by high gross issuance, though low net issuance. The limited supply of loans has been driven, in part, by a lack of private equity deal flow. This scarcity has set the stage for a surge in CLO resets, where mature portfolios are being reworked to take advantage of tighter spreads.

Yet, despite the optimism surrounding potential private equity deal origination in 2025, some market participants were skeptical about how much volume will materialise. There are several reasons for this hesitation.

First, looking at private equity fund performance over the past decade, multiple expansion has contributed to more than half of the returns, one panellist said. With public valuations at record highs, PE executives face a difficult challenge, namely deploying large amounts of capital when entry points are costly. While many sponsors may reassure their LPs that they are focused on operational improvements rather than relying on multiple expansion, behind closed doors, they are acknowledging the need to be highly selective.

There is considerable pressure from LPs on private equity sponsors to return capital. This has been building for the past two years, and many sponsors have delayed selling assets, hoping for a market rebound driven by rate cuts. However, as we move into 2025, this strategy may no longer be viable. With top-line growth slowing for many companies and demand weakening, sponsors now face the challenge of selling businesses at lower multiples than they could have in 2023.

"It feels a bit optimistic to expect a surge in private equity volume next year that will directly translate into new loan issuance,” said one panellist. “The market will likely remain subdued due to high rates and the pressure on private equity to focus on return capital."

3. Repricings dampen otherwise bullish CLO equity investors

Investors on several panels expressed an optimistic stance on CLO equity. The key appeal of CLO equity lies in its ability to weather high loss environments, preserve value in the face of volatility, and capitalise on market shifts when conditions change. One panellist succinctly captured the strategy: "CLO equity works today if you can preserve the math and downside risk, then trade aggressively when volatility arises." The ability to lock liabilities in at near historical tights adds an element of optionality that many investors found particularly appealing.

However, CLO equity is facing significant challenges. The market is dealing with a “double whammy” of spread compression alongside potential par losses due to shadow defaults. While CLO cash flows remain relatively healthy, yielding around 20-30%, these two factors create a more uncertain and potentially worrying environment for CLO equity investors. The looming threat of defaults, in particular, is seen as a more pressing risk.

As one panelist noted, “Defaults are a bigger risk for CLO equity than spread compression, although I think the spread compression will continue into Q1 2025 before it stabilizes.” This reflects a broader consensus that, while the loan market is on a stronger footing compared to previous years (given the continued high interest rates serve as a "disinfectant," cleaning up weak credits and reducing the overall risk in the loan market), the long-term outlook for CLO equity remains clouded by the potential for shadow defaults and ongoing spread tightening.

In the secondary market, CLO equity from 2023 vintages is seen as an attractive opportunity, although much of the call optionality is already priced in.

4. Rising role of LMEs

Capital preservation will be a crucial factor going into 2025; with the evolving landscape of LMEs, there is expected to be increasing dispersion in CLO equity and CLO double-B returns.

CLO managers without the resources to adapt to these shifts may struggle, as previously reported. As one panellist put it, the volatility in performance and recovery rates suggests that rating agencies may need to reevaluate capital structures, particularly for CLO managers, possibly distinguishing between those of different scales or resources.

Smaller CLO managers, in particular, may find themselves at a disadvantage. The size disparity matters more than it did in the past, especially when the ability to navigate complex scenarios, like shadow defaults or restructuring, is crucial. One panellist noted, “New managers may not have as many stressed credits now, but in a few years, they will have ‘tails’ in their portfolios, and with LMEs continuing, larger managers may achieve better recoveries.”

Indeed, default recoveries from current portfolios are estimated at just 58%, compared to the historical average of 70%. The likelihood of sponsors trying to extract value through complex maneuvers has increased, and while creditors have had some success in adding protections in documentation, the pressure is rising.

Shadow defaults, where borrowers face financial stress without officially defaulting, are a particular concern and could exceed 5%, with some speculating that haircuts for these transactions could range from 2% to 20%. As one panelist remarked, “Anyone who thinks that Trump (or any external factor) will save your balance sheet is wrong — it’s not going to happen.”

There has been a significant shift in the LME landscape over the last 24 months. This has evolved from simpler 51/49 splits to more complex negotiations where creditors may have to absorb significant losses. The trend is toward pro rata agreements, where creditors are treated equally, ensuring more predictable recoveries. However, in some cases, certain groups have recovered up to 22 cents more than others due to differences in their negotiation positions.

Despite the pain associated with these changes, there is some benefit. Documentation around LMEs has tightened, reducing the likelihood of such scenarios repeating themselves. This tightening ensures that, in future deals, sponsors may have to give up more of their equity or the company could face more significant restructuring. The key takeaway is that while haircuts and recovery losses are painful, they often lead to more robust structures that protect investors in the long run.

The role of unsecured bonds in the CLO space has also shifted. In the past, there was emphasis for senior lenders to have unsecured risk below senior capital to help protect the structure. However, this has been flipped on its head in the LME world. Now, unsecured bonds trading at steep discounts held by large institutions have the power to influence sponsors. As one panelist noted, “What was once a strategic advantage is now a vulnerability, as these institutions can push sponsors into reshuffling capital priorities, effectively junior-ising your position.”

The more favorable scenarios for CLO managers today are those that involve a co-op agreement where everyone is treated equally. This is increasingly seen as a safer structure, where all creditors face the same terms, helping to maintain a more predictable and stable recovery process.

5. CLO adaption to LMEs

The rapid pace of the LME development means CLOs need to adapt quickly to mitigate risks and ensure they can navigate these shifts effectively.

Historically, CLOs have been able to absorb troubled credits with an ability to take equity. However, the dynamic has shifted. As one panelist noted, “CLOs can no longer afford to wait —they need to be much more responsive when dealing with distressed assets.”

The advent of new technologies and evolving market conditions means investors must act quickly to manage downside risks. While CLOs may have previously created sidecar vehicles to hold troubled credits, offering a path for continued participation in distressed situations, the real challenge now lies in “how portfolios are structured, rated, and how much capital can be allocated to new deals”. The liquidity of these assets and their market pricing are also critical factors influencing CLO strategies.

As CLOs adapt to LMEs, greater flexibility in portfolio structures becomes essential, said one panellist. This includes allowing for more flexible ratings, the ability to incorporate PIK instruments, and other adaptive strategies to preserve capital and ensure robust recoveries. "Documents need flexibility for LMEs — what we’ve learned is that hedge funds and sponsors alike can interpret CLO docs creatively, sometimes even exploiting them."

Some CLO debt investors, especially those at the top of the capital stack, may resist this flexibility due to concerns over losing control, or predictability. However, many equity investors see flexibility as crucial for preserving par value and ensuring that CLOs can weather tough market conditions. As one expert noted, “If managers have the flexibility to make strategic moves, it’s to everyone’s benefit — it helps preserve equity value while maintaining a fair outcome for debt investors.”

Despite the increasing flexibility that CLO managers may have, there are concerns that LMEs are not adequately protecting debt holders. One issue is how CLOs treat LMEs in terms of their impact on the OC ratio. Currently, when a loan falls into distress and undergoes an LME, the loan may continue to be classified as a triple-C rated asset, even though the loan has technically defaulted. Envision or Diamond Sport are two examples where loans were trading in the 20s or 30s, but still classified as triple-C.

One suggestion put forth by a panellist was that CLO documents should immediately adjust the OC ratio to reflect the haircut once an LME occurs. If a loan is undergoing an LME, the haircut should be applied to protect debt holders early in the process.

6. Uncertain outlook for leveraged loans

Entering 2024, many expected signs of a recession to become more evident, but so far, the economic landscape hasn’t seen the sharp downturn anticipated. While top-line growth for many companies has slowed, their ability to control costs and expand EBITDA margins has helped maintain profitability. However, many remain cautious about the outlook.

Despite a brief period of price hikes in 2023, companies are now facing stagnant revenues and flat volumes, making it harder to pass on higher costs to customers. As a result, the risk of downgrades persists. On the positive side, the ratio of loan downgrades to upgrades has stabilised, and CLO managers are becoming more selective.

Despite the challenges, fundamentals remain strong. Over the past few years, companies have operated with a recessionary mindset, lowering leverage and managing costs effectively. As a result, many are better positioned to navigate ongoing uncertainties, even as revenue growth slows.

The market outlook for 2025 is becoming increasingly complex, particularly with potential shifts in policy and geopolitical risks. The evolving impact of tariffs, the potential for rate cuts, and emerging risks in Europe were cited.

In terms of sector positioning, there is a noticeable shift toward defense. Specifically, sectors like defense and aerospace could face increased volatility. Tariffs, if implemented, could affect multiple sectors, including automotive and technology, though the ripple effects of tariffs will likely “percolate across industries”, creating broader economic pressure. As a result, staying nimble and ready to adjust portfolio allocations is crucial.

There was also an underlying concern about interest rate policy. If tariffs are enacted, the US Federal Reserve may face more constraints in cutting rates.

On the international front, a European debt crisis has threatened to emerge , particularly in France and Germany.

7. ETFs and Europeans diversify CLO investor base

A large portion of investors entered 2024 with hopes of growing their CLO allocations. However, many have faced a significant hurdle with investments being offset by liquidations or amortisations, and struggled to meaningfully increase their exposure to CLOs. The only exception, however, has been CLO ETFs.

The CLO ETF market (and in particular JAAA) has gained traction with around $20bn in AUM. One panellist predicts that institutional investors — particularly insurance companies — will flock to CLO ETFs in the coming years, viewing them as both an investment tool and a hedging instrument. Another forecasted that inflows could surpass $15bn next year, a testament to growing institutional interest.

The rise of CLO ETFs offers several advantages, most notably transparency. This increased visibility helps to make the CLO market more accessible to a broader range of investors. Additionally, CLO ETFs help to “narrow the discrepancy between odd-lot and round-lot trades, a common issue in the CLO market,” said another panellist. As large asset managers typically break large blocks into smaller ones for allocation across accounts, CLO ETFs consolidate this process, making the market more efficient and easier to navigate.

In addition, more investors could be attracted to the asset class owing to performance. CLO triple-A ETFs have returned just 100bps less than traditional loan ETFs. This is particularly important given the rating gap of triple A versus single-Bs.

Private credit CLOs continued to grow their market share in 2024 and alongside the emergence of two private credit CLO ETFs. These ETFs are offering investors exposure to illiquid assets in a more liquid, tradable format.

However, panellists voiced concerns around liquidity of the market during volatile periods. Private credit marks also tend to lag behind the rest of the CLO debt stacks, and during such periods, and there is “often a disconnect between the NAV and the actual market value of the underlying assets,” said one panellist. This can complicate the creation/redemption process and create nuances for investors, the panellist added.

European investors also became an increasing force in the US CLO market. This year was one of the biggest for the volume of CLO tranches placed with European investors, according to one arranger. A key driver behind this surge is the anticipated decoupling of interest rate policies between the US and Europe. With the European Central Bank expected to adopt a more aggressive downward rate path, European investors are seizing the opportunity to buy US CLOs while the yields remain attractive.

There is also growing interest from Middle Eastern and Asia ex-Japan investors, reflecting a broader trend of global diversification in CLO allocations.

One potential risk to the CLO market lies in the steepness of the US Treasury curve, panellists said. For an extended period, the curve has been either inverted or flat, creating an environment for floating-rate products like CLOs. If the yield curve steepens as anticipated, investors may shift away from floating-rate investments, such as CLOs.

8. Long-term capital deployment in warehouses

The landscape for CLO warehouse facilities has notably shifted in recent months, with many managers now opting for a longer-term view on their capital deployments.

In contrast to the shorter-tenor warehouses seen during 2020 and 2022, where facilities were often opened post-locking of triple-A tranches, or remained dormant with little asset balance, the current trend leans towards warehouses with maturities of six to nine months. This approach reflects a broader strategic shift in the market toward more patient capital and a longer-term perspective.

Ramping up a CLO too quickly in this current environment can be detrimental to equity performance. Currently, around 95% of loans are trading at or above par, with 60% even trading above par. The goal is to “avoid building up portfolios during periods of excessive retail inflows, which can force CLO issuances at the wrong time, potentially resulting in buying loans above par or repricing loans,” said one panellist.

9. Evolving landscape for new CLO managers

There’s never been a better time to become a debut CLO manager. The compression seen across CLO tiering has created an environment where new entrants can potentially thrive but with a major caveat — there's never been more scrutiny on performance. The market today is more data-driven and efficient than ever, and investors are quick to identify underperformance. In recent years, even some well-known tier-one managers have seen their results fall short, and the market has responded with a sharper focus on performance analysis.

Panellists compared creating a successful CLO platform to assembling Voltron with five critical components that must align.

This includes capital commitment (a strong significant capital and aligning capital sources is crucial); securitisation and CLO expertise (manager must demonstrate technical proficiency in creating and managing CLOs); a strong credit team (strong credit analysts with a clear understanding of the risk/return profile and asset selection process are vital to long-term success); robust systems and analytics (to assess portfolio performance, market conditions, and risk management); and service providers (strong legal and accounting functions, ensuring compliance with regulations like EU and UK retention rules, alongside custodians, trustees, admin agents).