CLOs get real on risk as performance dispersion rises

Nothing beats an 11-hour flight back to London for evaluating the outlook for collateralised loan obligations (CLOs), having attended the Opal CLO conference in California. We’re returning home with some interesting takeaways and a very different vibe than we experienced at the same conference last year – not surprising given much has happened in 2025 and we’re sure 2026 will prove to be equally interesting. 

While the Opal CLO conference is a "global" conference, historically the focus has been very much on US CLOs. Last year we noted more European investors and CLO managers, but this year the attendance of European managers, as well as both European and Asian investors, increased significantly, showing that the CLO market has developed into a truly global market. US investors have always been large buyers in the European market, but this year we have seen even more US buyers investing in Euro CLOs as spreads generally looked more attractive in euro assets.

Getting real on risk

If we start with market sentiment, there has been a marked shift. Last year we came back and thought the US market was way too bullish, clearly focused on deregulation and the opportunities of a second Trump administration, but what a year it has turned out to be. The level of tariffs announced in April and the associated volatility, as well as idiosyncratic defaults in the leveraged loan market, were things that no one expected. And while away from equity US CLO performance has been decent, it’s clear that European CLOs have outperformed significantly year-to-date. This year, we feel the market is more realistic on what to expect and that positioning has changed quite materially. Having said that, given the uncertainty in tail risk we could be proven wrong once again.

If we move on to fundamentals, then the general conclusion is that corporates are in a relatively good place, but that pockets of risk are meaningful. Earnings have remained solid, and two more potential rate cuts from the Federal Reserve (Fed) – if delivered – should help further enhance interest coverage levels. Also, we note that the general feedback is that corporates have so far weathered the tariffs better than expected. But there are also areas that CLO managers are quite rightly nervous about. Sectors such as chemicals (more so in Europe than the US), retail and building materials are areas where we've seen various managers cutting risk. Then there is AI-related risk. While software remains a large allocation in US CLOs, the leveraged loan market doesn't directly finance AI development or data centres, with growing concerns around large capex spending more relevant for the investment grade corporate bond market.

Loan defaults and LMEs

Staying with loan market dynamics, we have seen record levels of loan refinancings in 2025 with companies successfully repricing their debt fuelled by strong demand for corporate credit. While this means increased interest coverage levels, and often extended maturities, it also means the asset income CLOs receive to pay for the CLO bonds that we invest in has decreased materially, making CLO equity look a lot less attractive in our view. We see this phenomenon both in Europe and in the US, but the levels of repricings have been far more material in the latter. The proportion of US loans trading above par is still around 50%, so we can expect loan repricing activity to continue in 2026.

At the same time, we have seen an increase in loan defaults and liability management exercises or LMEs (a longer way of saying restructuring), which have increased to 3-3.5%. The expectation from most analysts is that we'll see a small reduction in defaults next year, but that LMEs are here to stay. Lenders tend to be supportive of LMEs as they can achieve higher recoveries via this process than through bankruptcies. LMEs are cheaper for borrowers than bankruptcies and don’t require them to decrease leverage as much, and sponsors can also inject a small amount of equity, though this creates a risk that the capital structure will remain unsustainable and require further restructuring down the road. LMEs have become more or less normal in the US, and we see a great variability in outcomes between lenders depending on whether they are on the steering committees or not. The variability in outcomes between managers is something that was less relevant historically, which makes manager selection even more important.

2025 has been another disappointing year for new loan creation, but the general feedback is that both M&A and leveraged buyout activity is picking up in Europe and the US, mostly because of cheaper funding and lower corporate valuations but also as private equity (PE) has a need to release capital to investors. CLO equity has become more attractive for PE-type funds given similar returns and the fact they can get their capital back earlier. This new supply is very welcome for the CLO market as managers have been starved of new loans, and should hopefully dampen the downside from loan repricings so that CLO managers can improve the arbitrage (the difference between what the loans pay and what they pay to the rated CLO investors) for CLO equity investors. CLO equity is one of the few fixed income products where performance, because of repricings and LMEs, has been very challenging in recent months.

Performance dispersion in CLOs

CLO equity has seen mixed performance this year, and this is even more pronounced in the US. Across the globe we have seen some very large differences in performance between different CLO vintages and managers, and we expect this "tiering" to be even more pronounced as the economic cycle extends. We have seen managers deploying very different styles this year, especially in the US. The main trends have been around reducing position sizes and increasing granularity (to reduce LME risk on individual names), and reducing exposures to industries such as chemicals, retail and building materials. While not all managers have been so proactive, we are happy to see that some of our favourite managers aren't chasing risk and are increasing flexibility in their portfolios to benefit from, hopefully, wider primary supply. As we now see higher dispersion in the European loan market, we have started to see more pronounced tiering between European managers and also between CLO resets and new issues, a new trend we expect to continue next year and we think this is a healthy dynamic as risk is better priced in.

US and Japanese banks have been increasing exposure in recent months, and the expectation is that this will continue, while US insurance companies are expected to slightly reduce their allocation to AAA CLOs in favour of US investment grade (IG) corporate bonds as the spread differential has reduced. Overall, we expect the CLO market will continue its current growth trajectory as an increasing amount of capital is being raised by CLO managers for future CLO creation, so-called “captive equity”. Demand from European investors will likely increase, with pension funds continuing to increase their allocation to the sector and as further regulatory change for insurers and banks spur demand for AAA CLOs.

Due to this expected growth and with reset activity expected to remain busy in EU and US, most bank researchers expect to see some spread widening next year, typically around 5bp in senior notes and around 25bp in high yield notes. We believe that as long as collateral performance holds up, spreads will remain range-bound with a similar level of volatility as seen in 2025. However, as performance tiering further increases, we expect to see increasingly large spread differences, especially in BBB and lower rated bonds, between the (perceived) better and worse quality CLO managers.

US CLOs look expensive at IG level

So where does all that leave us in terms of allocation considerations? For AAAs we continue to favour European over US CLOs; there is currently a 25-30bp currency-adjusted spread differential here that generally makes Euro AAAs look cheap (at Euribor + 1.3%), and we think they can benefit more from an increase in insurance demand in the longer run. In IG, we see value in Euro AA and BBB notes (with spreads of around 2% and 3.25% respectively) and we continue to think the US is too expensive in these rating brackets. Lower down the capital structure into the HY space, we think BBs look interesting and it is also the part of the capital structure where we are increasingly seeing the value of diversification between both euro and US dollar bonds (at spreads of around 4.75% to 5.5%) with the aim of increasing liquidity and reducing idiosyncratic credit risk. New issue single-Bs have been the largest reduction in our allocation – we prefer shorter bonds here as we think the poor arbitrage and higher leverage isn’t currently worth the risk. 

CLO equity is a more difficult story, as at over 10x leverage it is much more exposed to fundamental performance and more aggressive LMEs in the future. We therefore prefer a European allocation in CLO equity, and we continue to like the late 2024 and early 2025 vintages from managers that have managed to keep their portfolios clean and flexible, especially as they locked in cheap and long-term funding and there is some future refinancing optionality. As the loan pipeline picks up, we could see value in new production as well, but we’d prefer to team up with managers during the creation (or warehouse) phase as the early carry can boost expected returns to 12-14%.