CLO popularity growing but secondary could offer better value

It has been two weeks since the primary market for collateralised loan obligations (CLOs) re-opened and 2025 has already proven to be quite a year from multiple angles.

Volume in the US has been nothing short of extraordinary, with 39 deals priced year-to-date at an average of four per day (the majority has been refinancings and resets). Looking at the deal pipeline there is little sign of a slowdown, with a similar number of deals being prepared for the next few weeks.

The European market has started at a slower pace, with last week bringing the first six deals of the year. Demand though has been astonishing with virtually every non-senior tranche getting 2-5 times interest. We are not surprised about this, for a number of reasons:

• Spreads in every single part of fixed income have moved tighter, with both European and US investment grade (IG) and high yield (HY) corporate bond indices trading close to historic tights. CLOs spreads, which tend to be slower to react, are sticking out as even cheaper than they already were; the premium we see on European BB CLOs versus European BB HY is around 300bp.
•  A new year means new budgets and new money to be deployed from real money accounts, hedge funds, banks, insurance firms and pension funds across the world. January has often been considered a risk-on month in the absence of any material negative backdrop. In addition, while the CLO primary market hit record volumes in 2024, net issuance was weak as refinancings dominated, meaning investors’ need to deploy cash is even higher.
• US CLOs started to move towards their 2018 and 2021 tights at the end of last year, driven by strong demand and investor confidence driven by the incoming Trump administration. European CLOs in contrast have lagged their cousins (likely because of typical “European bearishness”) and look attractive on a currency-adjusted basis, which is why US investors are currently looking across the pond. As of year-end 2024, European BB CLO notes offered around 75bp of spread pick-up versus US BB notes from Tier 1 managers.
• Fundamentals have been better than expected. Underlying credit performance has weakened in 2024 but is still in relatively decent shape. Notably, CLO holdings of leveraged loans rated CCC have risen to new highs due to a few large idiosyncratic issues (the widely held Altice being downgraded for instance), but defaults have moderated and remain below the long-term average. The same is true for the proportion of assets with cash prices less than 70.
• The negative rate environment is a distant memory and with the pace of the rate cutting cycle still uncertain, the power of income and carry on CLOs is hard to ignore: US and European AAA CLOs offer 5.2-5.3% yield in GBP terms (taking into account 12-month rate cut expectations) while BBs offer 8.5-9%.
• On a risk-adjusted basis, CLOs have again been one of the best performing fixed income asset classes year-to-date, after returns in 2024 outstripped corporate credit (see Exhibits 1 and 2).

In the last five years, the global CLO market has grown by more than 60% to total $1.3tr, and it has proven its resilience and liquidity on multiple occasions. Since more and more investors are acknowledging this and getting comfortable with the product, we are not surprised to see such strong demand and spreads grinding tighter. In the US, CLO exchange-traded funds (ETFs) have attracted inflows of over $3bn just three weeks into 2025, with the majority in AAA. This has contributed to a 10bp tightening of AAA spreads month-on-month, with a deal from Elmwood priced at SOFR+115bp setting a new record tight.

In Europe, BB CLO spreads have tightened 75bp from December levels to around 500bp now, and we hear there would be investor demand at even tighter levels. There has been a similar move in single-Bs. The tiering between managers is also shrinking but still present, with smaller and less established managers pricing with a 60-75bp premium at sub-IG level in Europe and 200-250bp in the US.

So where do we go from here?

In general, the current market backdrop seems to be setting up fairly similarly to what we witnessed during other periods of CLO primary market spread tightening, most notably in 2018 and 2021. The weaker returns that ultimately characterised those years however were driven mainly by negative rates and Covid-19. In the current macro environment, moderate growth is good for credit and by extension CLOs. Rate cut expectations are likely to remain uncertain and keep the income component of CLOs higher for longer. Given the strong technical, we expect spreads to continue to tighten modestly in the short term. Furthermore, the current leveraged loan repricing wave is another reason primary CLO AAAs are likely to tighten further from current levels, given the historical correlation between loan spreads and CLO AAAs. The lack of M&A activity contributes to this by limiting net supply. Nevertheless, we detect early signs of more positive sentiment towards a return of new money activity, driven by rate cuts and an ever-growing need for private equity to exit investments.

While we think spreads still look fairly attractive here versus corporate credit, and as long-established investors in CLOs we welcome their growing “popularity”, tail risks are still present in the broader market. We feel that some investors are chasing risk at present, and with the luxury of being fully invested we generally tend to feel that these are periods to be vigilant and avoid over-reaching in primary. Paper offered in the secondary market could offer better value in our view and help keep credit spread duration short without sacrificing returns.