CLO equity returns in a tight spread environment

How can investors evaluate CLO equity opportunities amid today’s historically tight CLO liability and loan spreads? In this piece, we dive into several frameworks investors can use to model potential future performance and consider the CLO equity opportunity set in 2025.

Framework 1: CLO arbitrage — It’s all relative

The relative relationship between CLO liability spreads and bank loan collateral spreads, otherwise known as the CLO arbitrage (arb), is the first framework to consider when evaluating today’s CLO equity opportunities. Each deal and vintage may follow a wide range of paths during its life that determine returns, but the arb can serve as a good proxy for the early income profile. This relationship moves daily with changes in liability and loan spreads, and there is a healthy codependence that has historically kept the relationship in check: 

• CLOs are the largest buyers of bank loans, so if the relationship becomes unattractive, CLO creation may slow, potentially leading to lower demand for bank loans (wider spreads) and lower supply of liabilities (tighter spreads). 
• The inverse is generally true when the arb is abnormally wide; it may lead to greater CLO creation to capture the arb, resulting in greater demand for loans (tighter spreads) and larger supply of liabilities (wider spreads).

This dynamic has historically made CLOs one of the few credit assets that has been relatively indifferent to absolute levels of spreads. As long as this arbitrage relationship is healthy, the investment case may remain intact.³ 

So, amid today’s historically tight spreads across credit markets, we believe CLO equity investors should continue to focus on the relative relationship and their outlook for defaults. 

Critically, we observe the arb/yield at deal creation today in the low teens and have a benign outlook for loan defaults. This could suggest a potentially favorable environment to deploy capital into equity.

Framework 2: So many options!

The second key framework to consider is the asset’s inherent optionality. CLO equity investors have two important options: 

• The option to finance/reset/call a deal at any point after the investment period
• The option to reinvest the collateral pool during the reinvestment period

The values of these two options can vary depending on the environment. For instance, in a period when a deal is issued with historically wide liabilities, the value of the refinance option may be particularly high. This is because there is a high probability that investors can refinance in the future when liability spreads tighten. In contrast, the option to reinvest is most valuable when loan collateral spreads are historically tight, because it means there is a higher probability that they can capture greater income when spreads widen. 

Figure 1 highlights how CLO AAA liabilities have been historically tight recently. In fact, they were at the 0^th percentile as of the end of January. For equity investors, this suggests two things: a) it is a historically good time to lock in a low cost of financing for their collateral pool; and b) their optionality to refinance at tighter spreads in the future is lower than it was two years ago.

Figure 1

Conversely, bank loan spreads are historically tight at the 10^th percentile. This suggests two things for equity investors: a) the current income from their loan pool is lower and dollar prices of loans higher; and b) their optionality to reinvest at wider spreads over the typical five-year investment period is quite high. 

In fact, over the past 20 years, bank loan spreads have widened above the 75^th percentile in 100% of rolling five-year periods.⁴ We believe that locking in historically tight spreads and assuming volatility/loan spread widening during the reinvestment period could potentially lead to good outcomes for equity. Importantly, the risk is that loan spreads continue to grind tighter, and income is eroded until deal liabilities can be refinanced tighter in the future (typically, two-year non-call).

Framework 3: IO not PO

CLO equity returns can be divided into interest-only (IO) and principal-only (PO) components. When loan prices are normalized but the arbitrage is wide, the IO component tends to drive returns. Conversely, when loan prices are at a steep discount but liabilities are wide, PO return potential may be high. Currently, with a healthy arbitrage and about 63% of bank loans trading above par, the return stream is heavily IO. In contrast, during 2020 – 2022, when loans traded at steep discounts, but income was challenged, the returns were heavily PO driven. We think it makes sense in this environment to haircut loan spreads assuming further tightening as this loan refi wave continues. If, under this more conservative analysis, investors arrive at an attractive potential return, we believe they may find this opportunity particularly compelling since there is asymmetric potential to increase income in the future if loan spreads widen off historic tights. However, the risk is that spread compression assumptions may not be conservative enough, leading to income erosion through repricings without an uplift in spread from volatility.

Bottom line on CLO equity investing in today’s environment

Historically tight spreads appear to be creating opportunities for CLO equity investors. We believe today’s environment presents an attractive arb with potential upside if loan spreads widen out in the future. In this way, we view the asset class as a potentially effective opportunity to maintain income in portfolios, with a possible call option on future volatility/spread widening.

¹Source: JPMorgan AAA CLO Index. | PAST INDEX OR THIRD-PARTY PERFORMANCE DOES NOT PREDICT FUTURE RETURNS. | Historical spread analysis based on trailing 10 years of daily spreads as of 31 January 2025. Percentiles are based on trailing 10 years of daily spreads as of 31 January 2025. CLO spreads are based on SOFR discount margin to worst from 31 May 2022 onward; Prior to 31 May 2022, CLO spreads are based on LIBOR discount margin to worst +26 bps (ARRC recommended credit spread adjustment) to account for the difference in the LIBOR/SOFR basis. | ²Source: JPMorgan AAA CLO Index and Morningstar LSTA BB/B Leveraged Loan Index. | PAST INDEX OR THIRD-PARTY PERFORMANCE DOES NOT PREDICT FUTURE RETURNS. | Historical spread analysis based on trailing 10 years of month-end nominal spreads as of 31 January 2025. | ³Credit investors may understandably question the idea that spreads don’t matter. Naturally, the absolute spreads on CLO liabilities and loan spreads matter to CLO buyers, as it is crucial to ensure the level of spread appropriately compensates you for the credit risk. However, when arbitraging the two, the focus may shift more toward the default experience on loans and their spread relative to the spread on liabilities. This approach is much more about managing the asset-liability relationship than evaluating prevailing spread levels in the market per unit of risk. | ⁴Source: Morningstar LSTA BB/B Leveraged Loan Index. | PAST INDEX OR THIRD-PARTY PERFORMANCE DOES NOT PREDICT FUTURE RETURNS. | Data based on month-end discount margins (DM) with a three-year life for the index from 1 January 2002 to 31 May 2024. This exhibit is shown to depict the volatility of bank loans and the frequency that loan spreads trade above the 75% percentile. There is no guarantee loans will trade above the 75% percentile during a CLO reinvestment period.