Another important and emerging trend is the divergence between the types of companies tapping BSL versus private credit. Historically, when a company was under stress with a potential downgrade to CCC, it faced a borrowing cliff. CLOs are the largest buyer of bank loans and have tight restrictions on their ability to own the lowest-rated debt category of CCC. This often meant that loan prices would hit an air pocket between CLO demand and distressed buyers who buy at lower prices. Private credit has emerged as a natural buyer of those challenged credits, taking the loans private, offering more creative lending terms bilaterally, and potentially earning a higher spread while doing so. This has shifted some of the riskiest loans off the balance sheets of CLOs and into private credit funds.
Bottom line for CLO equity
The convergence of public and private markets has thus far benefited CLO equity by improving credit fundamentals. High CCC exposure and defaults have historically been the primary risks to CLO equity tranche holders, potentially restricting trading activity and reducing future interest and principal payments. Private credit entering the market as a buyer of these loans was an unexpected but welcome development.
Critically, though these loans are trading at stressed prices, they are refinanced at par. So, CLO equity goes from owning a credit trading at a steep discount that could take a principal loss to instead being paid back at par. As long as this trend continues — and given today’s ample dry powder and strong demand for private credit, we expect it to — CLO equity could be a significant beneficiary of the growth of private credit.
The flip side of this coin is that private credit taking market share from the bank loan market has the negative technical impact of tightening bank loan spreads because of lower loan supply. We see this today with almost 60% of BSLs trading above par.1 This reduces the income and potential price appreciation to equity buyers when creating CLO collateral pools. We are less concerned about this trend because the CLO machine has the natural regulator of the equity arbitrage. If loan supply drops, leading to tighter spreads/higher dollar prices, new CLO creation is likely to slow. All else equal, CLO issuance should slow over time at a pace that leads to an equilibrium between the two markets and should not be a long-term challenge to equity returns.