There is a curious paradox at the heart of the European CLO market. The average arbitrage for equity investors is woefully unattractive — yet CLO managers are still able to price deals, apparently unaffected.
In fact, Deutsche Bank has forecast €65bn of new CLO issuance in Europe this year. If correct, this would exceed last year’s bumper crop of roughly €60bn of new issues.
Arbitrage is the word used in the CLO market for the difference between the total spread on a deal’s assets and its liabilities. This income flows through to equity investors as return on their capital.
For several months, the arbitrage has been squeezed, relative to historical levels.
Since January 2025, the average arbitrage on new CLOs, expressed as a spread on the whole capital structure, has languished below its seven year average of 208bp, according to Deutsche Bank calculations. At the end of this January, it was just 144bp.
With equity tranches typically making up about 10% of a deal's capital structure, this means the return on such a deal has come down from about 21% to 14% — and that is before any losses, and possibly before fees and other costs.
The arbitrage fluctuates naturally as CLO managers buy and sell loans and reset or refinance deals, altering the spreads on a deal's assets and liabilities.
But a continually flattened arbitrage does translate into lower equity returns.
Market sources have said it is now not uncommon to see equity returns in the single digit percentage range, when historically investors expected returns in the mid-teens.
Returns have even been low enough to fall below those of the single-B rated notes on some deals. Yet CLO equity is first in line to take principal losses if any of the loans in a deal defaults.
Shrinking arbitrage is largely the result of a months-long trend of asset repricings, as leveraged loan borrowers come back to the market to refresh their loans with new ones at tighter margins. Some €30bn of these deals took place in January alone, research from Bank of America shows.
Meanwhile, the supply of new leveraged loans in Europe has slowed, but demand from CLOs has remained unaltered, allowing loan issuers to tighten spreads continually.
CLO liability spreads have also tightened in the early weeks of this year, bringing some relief to managers. But they have not tightened sufficiently to improve the arbitrage meaningfully. Should it remain at present levels, equity returns will continue to disappoint.
Rebalancing impeded
The need for CLO managers to attract equity from third party investors used to ensure that the arbitrage remained healthy. If loan spreads tightened too far to make CLO equity attractive, managers would struggle to raise equity and CLO issuance would slow.
This would, in turn, force loan issuers to offer wider spreads, reviving demand from CLO liability investors, tightening liability spreads. Wider asset pricing and tighter liability spreads improved the arbitrage, restoring demand for CLO equity and order to the CLO universe.
But EU risk retention requirements spurred CLO managers to establish captive equity funds. Initially designed to hold the risk retention pieces of CLO equity, these funds have become a distinct asset class. The investors are managers themselves, alongside external investors.
But compared with raising fresh equity for each new deal, captive equity funds give managers more control of how and when they deploy capital, and more time to ride out difficult patches in the market.
Even when the arbitrage is low, managers can still use captive equity funds to issue CLOs.
Market participants often point out that “day one arbitrage” is not necessarily an indicator of future returns. Viewed over the multi-year life of CLOs, there is always time for the arbitrage to improve, and eventual returns might be better than the initial arbitrage would suggest.
It is also true that lower demand from CLO managers for leveraged loans after the surge of loan repricings in January has caused fewer loans to trade at or above par in the secondary market over the last two weeks. But demand from CLOs is still outpacing loan supply.
With captive equity funds helping to create conditions that lower CLO arbitrage, the market's natural rebalancing effect will not work as fast.
Captive equity funds allow managers to be more focused on management fees and increasing their assets under management than on the economics of CLO equity.
In this environment, there is a risk of CLO managers effectively issuing deals for the sake of issuing, rather than because equity returns actually make sense for investors.
As a result, CLO equity is being sheltered from the forces of supply and demand that ultimately govern the capital markets. As experience shows, market stress can be delayed, but not avoided.
If CLOs continue being issued at low arbitrages, the shock to demand when equity eventually takes significant losses will be all the greater.