Investors fond of a flutter should consider CLO equity right now. But only stake what you can afford to lose.
CLO equity has been an unrewarding asset class of late. These junior tranches of securitizations of leveraged loans make money from the 'arbitrage' between the CLO's cost of borrowing and the margins on its loan portfolio — and of course, the equity investors also have to absorb any losses on the loans.
Losses have been modest recently, but arbitrage has been measly. Loan repricings by leveraged borrowers that began last year culminated in a €30bn tidal wave of deals going through negotiated margin cuts in January, knocking holes in equity investors’ arbitrage.
And since the Iran war began, CLO bond spreads have widened, further eating into the arbitrage available on any new deal that comes to market.
Until recently, most leveraged loans were also trading at or above par, making it nigh on impossible for CLO managers to 'build par' — buy loans cheaply, hoping to sell them later at higher prices.
But since February, leveraged loan prices have been heading south, for the first time in months.
CLO managers have sold out of loans to software companies because of the threat to their viability from artificial intelligence.
They have also dumped positions in industrial sectors like building materials and chemicals, expected to be most affected by higher energy prices stemming from the Iran war.
Less than 10% of leveraged loans are now trading above par, Bank of America figures show.
The door to building par has creaked open. Managers can now ramp CLOs with cheaper loans, potentially increasing equity returns in the long run, although the arbitrage now remains thin.
There is some precedent for this technique succeeding. When Russia invaded Ukraine in 2022, loan prices softened because of higher energy prices, as they have recently.
Investors that took positions in CLO equity shortly after that war started were rewarded with some of the best returns in recent years.
Nonetheless, investing in CLO equity now comes with heavy risk. A long term change to how investors underwrite software loans is taking place. AI is changing so fast that it is difficult to price in its true effects.
Similarly, the length of the Iran war and its devastating impact on the global economy depend on the whims of a changeable US president.
These fluid and unpredictable risks could easily cause defaults in CLO portfolios to rise, wiping out equity returns.
Fortune favours the brave — but to invest in CLO equity now is to gamble with very high stakes.