For three years running, European CLO managers have enjoyed a new issuance bonanza. CLO volumes this year look set to top those of 2025 and 2024, both of which were already record years.
According to research from Deutsche Bank, new CLO issuance is likely to reach €65bn in 2026, up from €60bn last year.
But an insidious problem is lurking in the background for CLO managers that may be a drag on issuance. CLO equity returns are suffering under the weight of tight leveraged loan spreads and stubbornly wide spreads on triple-A rated CLO notes.
Waves of repricings this year have compressed loan spreads. There have been roughly €87bn of repricings so far, with spreads on many of these deals sinking as low as 300bp.
Repricings offer lenders like CLOs the choice of accepting lower spreads or being repaid at par. Anaemic loan supply in recent months has obliged many CLO managers to accept repricings.
Tighter loan spreads resulting from repricings have led to worse cash-on-cash distributions to CLO equity investors.
Figures from Bank of America show that a third of deals within their reinvestment periods have paid distributions of less than 2% in this quarter — one of the lowest levels on record.
Even an incoming €25bn-€30bn surge in new loan supply is unlikely to make much difference to CLO equity returns. Spreads on much of the new loan paper are expected to be in the mid-300bp area, which is only a modest improvement.
Triple-A trouble
CLOs are an arbitrage product. Distributions to equity investors are derived from the difference between the income generated by CLOs’ loans and the cost of servicing the liabilities.
With loan spreads quite so tight, managers are dependent on getting tighter liability spreads to boost equity returns. But most CLO mezzanine spreads are already at historically tight levels.
Data from Barclays shows that on all mezzanine tranches except single-B rated tranches, average spreads are within the tightest 3% of spreads in the last five years.
There is little scope to tighten these spreads further, leaving managers with only the prospect of lowering spreads on triple-A rated tranches.
Triple-A spreads are, however, notoriously sticky. They have sat immovably at mid to high 120bp area for much of this year, having languished around the 130bp mark for most of last year and the second half of 2024.
The simple fact is that in Europe, there are too few triple-A investors and too many deals. It is an investors’ market.
Triple-A spreads were about 40bp-50bp lower than current levels in 2021 when interest rates were negative. Euribor is floored at zero on CLO notes and CLO triple-As were popular in 2021 as a result, which lowered spreads.
The inflationary impact of the Iran war means that there is little chance of rate cuts any time soon and triple-A spreads are unlikely to drop back to 2021 tights.
Changes to the Solvency II regulations are expected to allow more insurers to invest in CLO triple-As from next year.
The presence of more triple-A investors would almost certainly lower spreads, although it is unlikely that a flood of insurer capital will arrive immediately. Insurers will need time to develop their CLO investing expertise.
Not even the renewal of many banks’ budgets in September has moved triple-A spreads. Banks are among the largest buyers of CLO triple-As. Triple-A pricing appears to be well and truly stuck.
Evaporating equity
In that triple-As make up roughly 60% of the CLO capital stack, they have an outsized influence on their cost of capital. If CLO managers cannot move triple-A spreads tighter, the effect of persistently wide spreads is going to bite.
Average CLO equity returns have been in the high single digits for months, where once investors could expect returns in the mid teens. With high triple-A spreads weighing on the arbitrage, this will not improve any time soon.
CLO equity returns are slumping and it is going to be more and more difficult for managers to raise third-party equity for their deals. Few managers these days even attempt to sell majority stakes in individual deals.
Managers have only been able to continue printing deals so far because most of them can rely on their captive equity funds. These funds mix capital from managers’ balance sheets with outside capital and are used to fund equity contributions across multiple CLOs.
But captive equity funds are not an inexhaustible resource. When managers deplete their funds, they will need to approach investors for further capital. Funds with disappointing returns will not be easily replenished.
Equity is an essential part of any CLO and managers cannot print deals without it. If investors turn their backs on captive equity funds, it will be much harder for managers to issue new deals.
For the current rate of CLO issuance to continue in the long term, loan spreads must widen or triple-A spreads must tighten.
If spread levels remain unchanged, CLO equity investment will gradually slow and managers will print fewer deals. Something in the CLO market has to give.