A difference of opinion in US and European CLOs

Last week, members of TwentyFour’s asset-backed securities (ABS) portfolio management team were in Dana Point, California for the Opal Group CLO Summit, an annual event with over 2,000 participants made up of investors, bankers, CLO managers, service providers and lawyers. Three days in the California sunshine followed by a flight back to London in the midst of Storm Darragh was a neat parallel with our current view on CLOs: a bright outlook but with meaningful risks for investors to keep in mind.

In the last couple of years, the CLO market has been reshaped to become truly global. Historically the Dana Point conference was almost exclusively focused on US CLOs, but an increasing number of European investors and CLO managers are now attending (around half of the active European CLO managers were there). This is largely the result of more investors participating across both markets (we’ve spoken to plenty of both US and European investors now doing so), helped by the high degree of correlation between the two and the fact that many CLO managers have both US dollar and euro CLOs outstanding.

Our own approach is reflective of this trend; TwentyFour has been investing in European CLOs for well over a decade now, but only this year have we looked to allocate to the US. As we’re now late cycle when relative value can shift, we believe the increased diversification of both risk and liquidity offered by US CLOs may prove valuable in the future. Our focus for this conference was meeting CLO managers, traders and bankers that we don’t already see every few weeks in Europe. The US CLO market is around four times the size of Europe’s, but just like its counterpart it has its own advantages and challenges.

It has clearly been an incredible year for CLOs, with a combined $155bn of new issuance and $250bn of CLO refinancings across the US and European markets already breaking post-2008 records. Demand for the asset class has also been strong, supported by robust fundamentals; with defaults and distressed levels in leveraged loans (the “raw material” that makes up CLO portfolios) rising far less than was previously anticipated and now seemingly stabilising, some panellists at last week’s summit questioned whether we are indeed in late cycle, or if in the absence of a hard landing we have already moved into early cycle.

Despite record CLO issuance, new supply of leveraged loans has certainly disappointed. However, the general belief is that Donald Trump’s election victory and anticipated de-regulation will boost M&A activity in the second half of 2025, something that the market desperately needs to grow the pool of potential CLO collateral. Many companies have taken the opportunity to extend the maturity of their debt, but also at much cheaper margins. After a handful of rate cuts, and over a percentage point of spread tightening, many companies have seen their cost of financing reduced significantly. While leverage has remained relatively high, this has resulted in much healthier interest coverage levels. If you listen to the different research houses, then leveraged loan defaults should remain relatively low over the next 12 months, though the trend of liability management exercises (a broad term that includes an aggressive form of debt exchange by some private equity-owned businesses) will likely persist. The general thinking is that every loan trading below a cash price of 80 will end up in some form of restructuring in the coming 12-18 months, so CLO managers picking the right loans is very important at this juncture.

Across the three days we sensed plenty of optimism from both CLO managers and investors, and in turn from bankers and lawyers. While spreads have rallied significantly this year, the general consensus was that spreads will tighten further in 2025. For European CLOs, primary AAA spreads are widely forecast to tighten by around 20bp to 110bp over Euribor or SOFR. This should be driven by increased demand from primarily US and Japanese banks, partly as a result of more favourable regulation, but also increased demand from US CLO exchange-traded funds (ETFs) which have now grown to around $17bn in assets under management. Further down in the capital structure we’re hearing of US insurance and European and UK pension investor demand for AA-BBB rated CLO risk, while asset managers have reportedly been reliable bidders for BB rated risk.

However, what really stood out to us was a complete U-turn in demand for CLO equity on both sides of the Atlantic. Managers that rely on third-party equity investment were kept out of the market in 2022 and 2023 by a lack of appetite, but yield-hungry buyers have returned this year and around 35% of new issues have featured third-party equity, versus virtually zero in 2023.

So where does that leave us? We expect the healthy level of issuance to continue, demand will likely stay high or increase even further, and the economy looks supportive enough to keep defaults at bay. However, tail risk has not gone away in our view and the potential for a bump in the road is substantial. This is where we found a clear difference in opinion between investors based in the US and those based in Europe. US investors were generally focused on the new Trump administration’s expected boost to medium-term growth, while European investors seem to be more nervous about potential catalysts for spread widening, such as tensions in the Middle East, the recent escalation of the war in Ukraine, and struggling economies and political upheaval in both Germany and France.

As a result, we probably see relative value in different areas of the global CLO market than our US peers at present. Primary AAA CLO spreads of 125-130bp in both markets look attractive to us, but we think US spreads might tighten more aggressively and the size of that market results in our small preference for US AAAs here. In investment grade (IG) mezzanine bonds we have a strong preference for European BBBs, especially as spreads have widened a little bit recently, the combination of an extra 2% of subordination and 50-60bp more spread make them stand out versus US BBBs in our view.

In the sub-IG bracket, we think BBs have tightened a long way, especially in the US, and the appeal of primary BB paper isn’t what it was three to six months ago. Therefore, we prefer secondary (and shorter) BBs and selectively both secondary and primary single-Bs, to keep spread duration limited. We are seeing a great deal of spread divergence in the sub-IG bracket between the perceived better and worse quality CLOs (and managers) in the US, which we think is justified and we expect to see a similar spread “tiering” in Europe in the coming months. European BBs currently look more attractive than US BBs, and in general the carry available on sub-IG CLOs should be attractive for investors given how tight sub-IG (high yield) corporate bonds are in both regions right now.

In general, we think the technical will remain very strong in the first three-to-six months of the 2025, but we would be wary of chasing yield here and prefer to stay liquid and flexible in order to target any shifts in relative value we see across the capital stack in both Europe and the US. In CLO equity, we think late 2025 or 2026 may offer a better entry point for the 2025 vintage due to cheap liabilities and long reinvestment periods.