CLOs are finally pricing the tail

For some time now, collateralised loan obligations (CLOs) have in our view been one of the standout risk-adjusted opportunities in all of fixed income, and in recent years (including this one) their performance has lived up to that billing.

However, the story is now a little more nuanced as price tiering – a greater range of pricing between different CLO managers and vintages – is finally emerging. We say finally because for some time now we have also been mindful that the lack of price differentiation in CLOs meant the market wasn’t reflecting tail risk (i.e. the probability of meaningful losses) correctly. But after some high-profile idiosyncratic defaults, a clear difference has emerged between CLO managers who avoided problems and those who did not. This is a good thing.

Performance strong despite spread widening

Despite the recent spread widening of around 50-75bp in BB CLOs, they remain the best performing segment across rated US and European CLO tranches in 2025. According to the JP Morgan CLO indices, European BBs have returned 7.0% and 8.2% in euros and dollars respectively year-to-date, significantly outperforming both the high yield bond and loan markets globally again. CLO equity performance has been more mixed, as cash payments have been healthy but some managers have been caught out with larger exposures to weaker names and their lower valuations have offset the payments for equity holders.

None of this is beyond what we expected to see at the start of this year, with carry being the main driver of performance. Now that spread tiering has emerged, with the spread difference on BB notes between a “tier one” manager or deal and a “tier four” manager or deal having increased to around 250bp in Europe and as much as 400bp in the US, we believe CLOs are priced much closer to fair value than has been the case in recent months.

Where next for CLOs?

What is more interesting today is the degree of tiering, and where CLOs might go from here. If we start with the collateral, we can see that loan defaults have remained low at 0.9% and 1.5% in Europe and the US, respectively, but if we include restructurings (including so called liability management exercises or LMEs) then the picture looks weaker at around 3-5% in both jurisdictions (definitions of default events do vary). Loan recoveries have also recently reduced to around 60% in Europe and around 40% in the US, but these are all relatively heavily skewed by the 90% loss severity on First Brands, which defaulted following fraud.

If we consider holdings of CCC rated assets within CLO portfolios, these have remained relatively stable, despite a pickup in downgrades. Loans trading at distressed levels, which we define as loans trading below a price of 80, have increased to around 5% in Europe (from 2% at the start of this year), back to levels last seen in early 2023. We also closely track the part of the loan market that trades at cash prices between 80 and 95, and these are primarily loans in sectors such as chemicals, automotive, business services (where some names are more at risk from AI), and French laboratories in the healthcare sector. The general comments we get from CLO managers and researchers is that these are mostly idiosyncratic names that drive the indices, though of course the sensible question is how many idiosyncratic names represents a trend, especially as most of these are relatively cyclical sectors. 

The recent pickup in loan price volatility has also meant that liquidation net asset values (NAVs) and market value coverage levels have decreased across the entire market. This is the negative, but on the flipside loan pre-payments are still very high (some have also refinanced into the private credit market) and loan maturities have been pushed out dramatically, with very few loans now sitting with maturities between 2025 and 2027. In Europe, corporates have benefited more from rate cuts, as the European Central Bank (ECB) has cut rates to 2%, as well as margin compression, which has helped improve interest coverage levels materially over the last 18 months. Ultimately then there are currently two sides to the loan market story, and suffice to say credit selection has become increasingly important.

Price tiering helps with risk selection

Certainly the overall picture for HY CLOs doesn’t look as great as it did in January, though this is probably true for HY bonds and equities as well. However, if we look across individual CLO managers, we can now see a gap between managers that have avoided most if not all problem names, and managers that have not been so lucky and some of their older (and deleveraged) CLOs have over 5% defaults in the portfolio. This is evident in prices and liquidity, especially when you consider BB/B CLOs, but even more so in CLO equity. This was a differential that barely existed in very tight markets earlier this year. For CLO investors there have been periods of weakness (Q1 and Q3) for adapting portfolios, and those that took the opportunity to move up in credit quality and towards top performing managers will now be seeing the benefits. 

We can state that tail risk has increased in credit markets, and that means asset allocation, due diligence and cashflow modelling become more important. As there is no shortage of data in the CLO market, picking the risk that you’re willing to accept is arguably easier than in many other markets. This can be easier in US CLOs than in European CLOs, as the US market tends to offer a greater degree of diversification in collateral pools (financing 250+ companies) whereas the European market is more concentrated and it is common to see managers with a 2% single name exposure.

For that reason, our analysis of the two markets is different – in the US we focus on industry exposures and in Europe we focus more on overlap and concentration risk in single names. The beauty of CLOs is that investors have got structural protection, and investors demand more of this protection in the structuring of European CLOs due to the higher concentration risk.

Looking ahead to 2026

Various investment banks have already released their forecasts for 2026, and the consensus seems to be that leveraged loan (and HY bond) defaults will stay in the 3% to 3.5% range in 2026 globally. In this scenario, BB CLOs should again significantly outperform the loan and HY bond markets as these default levels just aren’t material enough to cause problems for CLO bondholders.

In terms of relative value, in investment grade European CLOs, AAA and BBB notes stand out to us at spreads of around 130bp and 335bp in primary markets, while in HY CLOs we still prefer the better quality BBs at a spread of around 550bp and here we see value in a degree of diversification between European and US CLOs. We see very selective opportunities in longer dated equity notes at yields of around 16%, but only from a handful of CLO managers that we think are best positioned to benefit from loan volatility (and only in vehicles with long-term committed capital).

It is fair to say it has been an eventful year in global CLOs, and we would expect some level of volatility to continue until there is more certainty around leveraged loan performance.