CLOs – a mature asset class in strong demand

Let us approach the term collateralised loan obligation – or CLO for short. How can it be defined, and how do CLO investments work?

Jakob von Kalckreuth: CLOs are arbitrage vehicles. They make use of the broad risk diversification and low default rates within a widely diversified group of corporate issuers rated in the sub-investment-grade segment. Through this risk diversification, they can issue higher-rated debt tranches and achieve differentiation, or a spread differential, on the liability side – that is, in the liability stack. This tranched vehicle is rated AAA to a large extent – around 65%. Below that, there are further, more subordinated tranches down to equity. Within this three-tier tranche structure, investors can select their preferred risk/return profile.

Ian Bettney: At its core, and beyond the complexity, a CLO is a loan fund that is effectively financed as an arbitrage vehicle through the issuance of a capital structure of bonds. This capital structure also includes equity. One important point is the locked-in liability profile. From an investor’s perspective, there is effectively no refinancing risk in the vehicle. Put simply: it raises financing by issuing bonds in order to invest in a pool of corporate loans. And in the middle, this arbitrage is captured.

Lewis Emmons: CLOs are securitised instruments that enable asset managers to package a portfolios of loans to leveraged companies, which have historically used the proceeds for LBOs and M&A activity, into tradable debt securities They are a traditional form of securitisation in that the security is structured into individually-rated tranches of diversified loan pools. A key difference from other forms of securitisation is that the loans within the portfolio can be managed. If you invest in a CMBS or RMBS or asset-backed security, the loans in that pool are typically fixed. In a CLO, you can add new loans and sell loans in order to optimise returns.

Christian Leuchtweis: We also need to distinguish whether the portfolio contains broadly syndicated loans or whether it is middle-market direct lending, which has grown significantly with the private credit asset class during the last ten years. That makes a difference in terms of the liquidity of the underlying loans and the question of whether they can be traded, distributed and reallocated.

Stamatia Hagenstein: Two features matter most for investors here: first, the portfolio is based predominantly on senior secured loans. Second, alongside the primary market there is a functioning, liquid secondary market for tranches. CLOs are therefore not illiquid loans locked into a rigid securitisation, but actively managed loan portfolios with tradeable tranches.

The CLO market has grown very rapidly over the past five years – in the US as well as in Europe.

Tilo Kraus: Yes, it goes hand in hand and is also connected with the refinancing of private equity acquisitions and with the growth of the private equity industry. There is demand for LBOs that need to be refinanced. For insurers and pension funds, it is much easier to invest in insured, rated and protected products in the upper part of the capital structure. That is driving growth. The largest players in this area are simultaneously private credit and private equity houses. Private credit, private equity and a CLO platform are often combined under one roof, because this allows the entire capital structure to be covered and investors to be offered comprehensive access to these markets. This represents a fundamental problem: if, as an investor, you are invested in a large pool or in the universe of CLOs and at the same time wish to invest in private equity funds, you are ultimately refinancing your own portfolio. This represents a form of correlation risk that a macro allocator should keep in mind.

Lewis Emmons: I also think that, from a demand perspective, the technical factors suggest that this is currently a very attractive time to invest in CLOs. Many of our clients are looking for investments with higher yields without taking on a correspondingly higher level of risk. They also want diversification in their portfolios, and CLOs are a very good way to build incremental yield and diversification into portfolios, both because of the complexity premium and the different types of issuers and loan exposures involved.

Which groups of institutional investors are currently investing in CLOs?

Lewis Emmons: It is broadly spread. Demand for alternative credit and multi-sector credit increased after the global financial crisis and is generally global in nature. Traditionally, most of our clients have sought exposure to structured credit within multi-sector credit strategies, where CLOs play an important role. There, demand is mainly aimed at the higher-quality segment, i.e. AAA and A tranches. However, CLOs are also very popular with insurance companies and with the changes to EU Solvency II regulation, we expect to see a heavier demand from this segment – from the mega-insurers down to smaller insurers. We are also seeing a growing interest in the asset class from pension funds.

Jakob von Kalckreuth: A good indicator of the demand profile is the buyers of our tranches in the primary market. Historically, these were Japanese megabanks. Today, we are seeing strong demand from the treasury departments of US investment banks for AAA tranches, the higher-rated part of the CLO market. Typically, underwriters of deals take down significant parts of the senior portion of the capital structure because the capital treatment for this asset class is very efficient. The spread premium is a key reason for the attractiveness and strong growth of this market. Owing to its complexity across the capital structure, CLOs offer a significant spread pick-up. Further down the capital structure, there are more bespoke tranches, because the world becomes much more specialised there: we see pension funds, hedge funds and ABS investors. In the upper part of the capital structure, we are talking about investors who focus exclusively on this market. The ETF world has recently become an increasingly important player, especially in the US. This growth has been a driver of spread compression. I expect a similar development in Europe. On the equity side, the emergence of captive risk-retention vehicles has driven issuance and demand. Today, probably 70% of global equity is provided internally. It may be a repackaging structure of ISIN tranches, for example for a small pension fund that wants to allocate €20 million to a single manager. Such an investor is not in a position to value a single ISIN properly itself; instead, it would rather buy a captive equity fund that achieves a vintage effect across multiple vintages. Accordingly, the demand profile in equity, but also the return profile of CLO equity, has changed in recent years.

Stamatia Hagenstein: In the AAA space, banks, insurers and pension funds continue to dominate. At the same time, CLOs are reaching further investor groups through UCITS structures: our investment-grade UCITS fund is used mainly by companies, foundations and family offices. With the high-yield UCITS fund we launched last year, we created a structure that makes CLOs investable for a broader audience, again primarily for unregulated investors. Because investors in Germany have not been able to buy CLO equity tranches directly since the financial crisis, we also launched an equity note, to give professionally classified investors outside the core institutional circle a way to participate in the returns of this asset class.

Ian Bettney: Where did the demand come from, particularly over the past five years? Interest-rate volatility has a lot to do with it. We have now been in a rate-hiking cycle for almost five years. For years after the global financial crisis, I tried to persuade clients to take exposure to floating-rate credit. One of the best ways to obtain the safest exposure to floating-rate credit is through securitisations. But during the years of low interest rates, there was little response to this because we had negative rates. To me, that was free money at the time because CLOs had a floor. You could buy AAAs at an equivalent spread of 175 basis points, but still, the response from investors remained subdued. Then, when rates rose again from 2022 onwards, the world realised: you should not be long duration in investment-grade corporate bonds when spreads are extremely tight and you simultaneously have ten-year fixed-rate duration. How can this exposure and credit exposure be diversified? Many investors still want to have a fixed income allocation in their portfolio, but at this point without fixed-rate duration. These changes and considerations have brought securitisations into focus for broad market segments. That applies to banks, treasury departments, pension funds, insurers, retail, institutional investors and family offices. Even if we were to enter a rate-cutting cycle again, the regime of higher interest-rate volatility is defining the environment. If an investor still wants high-quality credit exposure similar to corporate credit, then securitisations are the way to go

Jakob von Kalckreuth: Over the past two decades, sub-investment-grade corporate credit – whether loans or tranches – was alternative capital. Back then, you had to fight to obtain a tiny allocation from an insurer. Today, this part of the market is a 5 to 10% allocation of the fixed income book for most pension funds and insurers, in order to manage duration. The experience of Japan’s banks in 2022 is telling: the regulator told them they should stop buying AAA CLOs. Instead, they bought Treasuries – resulting in the need to carry out a big capital increase because they were badly burnt on their fixed-rate exposure.

Bálint Vágvölgyi: Broad demand for CLOs exists simply because the asset class works so well, offering compelling relative value at all levels of risk. Every investor should be able to find a tranche that fits their investment need, unless prevented by regulation from investing in CLOs. We offer a range of CLO products and broad interest is visible from all major client segments, except for, until recently, insurance companies and retail investors. Solvency effectively prohibited insurance money in the asset class, except for a few idiosyncratic cases, like our parent company. Similarly, regulatory approval of a retail-accessible UCITS CLO funds used to be virtually impossible. Fortunately, recent changes in Solvency point towards increased insurance participation, even more so in the UK, where CLOs can now also be used for matching adjustment. Retail participation is also becoming easier with the recent shift in regulatory sentiment, which enabled launches of UCITS mutual funds and ETFs. Whether an investor buys senior or mezzanine depends often on the business model. If it is a family office, a pension fund or a bank treasury, that determines which part of the capital structure one buys.

Jens Anderson, what is R+V Versicherung’s motivation for investing in CLOs?

Jens Anderson: The R+V Group has been invested in this asset class for more than 20 years, and we focus in the highest-rated tranches. For us, it is a yield enhancement compared with short-dated corporate bonds or money-market investments. Acccording to our risk-return framework, given the low volatility below 2 percent, our return targets for this asset class are around 3 percent – that is the key point. We view CLOs as a semi-liquid asset class. hey do not represent a particularly large allocation for life insurers, as these companies require long-duration fixed-income investments to match their liabilities. The situation is different for property and casualty insurers, which generally have to match short-dated liabilities on the investment side. CLOs are a very good investment alternative for these insurers, enabling them to enhance returns and earn an additional spread pick-up. That currently amounts to around 100basis points over short-dated corporate bonds. Transparency within the tranches is always important to us. We want to know, for example, what proportion is accounted for by the top five or top ten positions. The Solvency reform makes the asset class even more attractive for insurers in the AAA segment. It could lead to greater spread tightening in AAA, which could be a driver for the asset class.

Ian Bettney: CLOs have always been, and still are, one of the most transparent asset classes among securitisations. Investors receive full look-through down to the individual loan level. An asset manager’s skill is reflected in how deeply they want to go and how much due diligence they require for the risk exposure they are looking at. With today’s data and systems, the possibilities for building analysis and efficiencies are effectively exploding.

Lewis Emmons: Transparency is generally one of the strongest arguments for securitisations. After the global financial crisis, the entire asset class was unfairly associated with the subprime mortgage market, but those problems were not a true reflection of what was actually happening in the broader securitisation markets at the time. Investors that have typically viewed the asset class with concern may not properly understand the nature of risks, and appreciate that very granular underlying loan data is available – in some cases this data stretches back decades and offers greater visibility than obtainable with conventional corporate bonds.

Jakob von Kalckreuth: It is up to each investor to decide for themselves how far they want to look into the individual bonds and loans. The technology for this exists, even though as a client you still receive a trustee report in archaic PDF format. At the same time, the more senior an investor’s allocation is within the CLO capital structure, the less they need to worry about their portfolio and the less relevant their own look-through becomes. The global default experience with CLO investment grade tranches over the past 20 years is spectacularly low and, cumulatively, practically zero.

Christian Leuchtweis: I wonder whether investors would actively use even more detailed reporting with all the statistics, financial data and credit metrics that goes beyond the current market standard.

Jakob von Kalckreuth: The more junior an investor is within the CLO capital structure, the more important maximum transparency is for correct valuation. This is appropriate for equity investors or junior mezzanine investors in the secondary market in seasoned deals – investors who are looking for an IRR of 15% plus. They should be able to value post-reorganisation equity in a CLO correctly when it is currently marked at seven. Only through deep look-through can one determine whether the reorg equity is ultimately worth zero or 25.

Stamatia Hagenstein: I would like to build on that point while also taking issue with it: an investor in the senior tranche, too, must actively manage their position. The principal risk here is not credit default but duration risk operating in both directions. Should the portfolio deteriorate, coverage tests may be breached, triggering an unplanned early redemption of the tranche. Conversely, should the portfolio’s expected weighted average life (WAL) extend, cashflows are delayed and capital remains committed for longer under the original, and by then less favourable, terms. A strong rating affords protection against neither scenario. We therefore continuously assess the documentation, the portfolio and the manager’s conduct in conjunction — particularly how the manager behaves once the reinvestment period has ended and it is no longer permitted to add new loans to the portfolio.

Bálint Vágvölgyi: Even if an investor is invested in AAA tranches, with virtually no credit risk, they should still think about managers’ behaviour and how that may impact their return. Particularly after the reinvestment period, some managers display aggressive behaviour, which can have significant effects. There is an inherent conflict between the senior lender and the equity investor in a CLO after the end of the reinvestment period. The more economic it is for the manager to let the seniors run, the less economic it is for the investor. The longer the equity retains cheap leverage in the transaction – i.e. the longer AAA is not amortised – the higher the IRR for the equity.

Do institutional investors today also invest directly in CLOs, or only via managers?

Bálint Vágvölgyi: Institutional investors can certainly invest in CLOs directly. The question is if it is economical for them to do so. Both common sense and regulation dictate that CLO investors should possess the ability to analyse the underlying portfolios and identify potential defaults. The lull of the period from about 2013 until COVID may have diminished the focus on loan defaults, but one must keep the following in mind: We often say that leveraged loans have an average default rate of 2.5 percent, but it is never 2.5 percent. It is either near 0% or much higher. When those default spikes come, investors should have a clear view of where their underlying risks lie. This requires expertise, which can be costly to have in-house. A cost-efficient alternative to direct investment is mutual funds or ETFs.

Tilo Kraus: From the perspective of end investors, CLOs sometimes encounter a certain scepticism compared to other forms of investment – whether justified or not. In the industry, CLOs are still indeed associated with CDOs and the financial crisis environment. When a portfolio manager appears before their investment committee, they therefore need expert support at their side. Vedra has the necessary expertise in this regard; however, many professional pension schemes and pension funds are not set up to the same degree. Even if the investment manager proposes a solid product in a tried-and-tested structure, getting it approved by the investment committee still requires considerable persuasion. To avoid this effort, some pension investors ultimately decide against a CLO investment. I would also like to raise a second point. CLOs are ultimately a correlation product with spikes. It is extremely difficult to predict when these spikes will occur. Timing – when to invest and when not to – is therefore essential from an investor’s perspective. And a third point is this: investments in CLOs are becoming massively more attractive for insurance companies as a result of far-reaching regulatory reforms – both in Europe through Solvency II and in the US through the NAIC. This is drastically lowering capital requirements for the safest tranches. We are convinced that whenever there are many regulatory changes driving money into one area or another of the overall capital market, you really have to ask yourself: am I buying into a regulatory-driven purchasing effect?

Jakob von Kalckreuth: I do not see CLOs as a correlation trade, but rather as an income trade, because they are income-oriented investments with relatively short weighted average lives. Investors are primarily concerned with yield.

Tilo Kraus: For us as investors, income naturally plays a role, but it rises and falls with the risk we take on for it. We have to serve a liability profile. The liability bucket into which a particular CLO tranche would be assigned would have to be longer than the weighted average life of the tranche itself, because we do not want to engage in forced sales at any point. I do not know how volatile the weighted average life actually is and how much extension risk I have in the product. I understand the idea of a floating-rate product. A pension investor like us does not necessarily have to match duration in the way an insurance company does. But for me CLOs are also a correlation product because I want to know: how correlated are the defaults in the underlying pools, and how correlated are the LGDs in the underlying pools? How correlated is that with my other risks? So if I have a large private debt book and at the same time a large CLO book, there are certainly correlations between the risk drivers that rise in times of crisis.

Jens Anderson: As a life insurer, what we like about the transparency of CLO investments is that we can see sector clusters and how the loan market is essentially allocated. We are indeed observing convergence in the market. Some deals are marketed in the high-yield or in the loan markets. Some private debt funds also invest in specific sectors.

Ian Bettney: I would like to return to your point about correlation-trade versus income-trade. I explain it to clients by saying that even for AAA, at least 80 percent of the performance is related to the current yield, particularly in this part of the capital structure. It is a spread product that correlates with the broader markets. Many investors think about where they can place it in their cashflow waterfall: one notch above cash, two notches above cash? A CLO is not a cash substitute; it is a spread-market product. In a broader market sell-off, spreads will widen, and this product will also sell off.

Can you explain that in more detail?

Ian Bettney: BBB CLOs correlate 80 percent with the iTraxx Crossover Index, with a beta of 1.2 and an R-squared of 75 percent. That is an almost perfectly correlated product in terms of timing, although crossover initially moves more strongly and more quickly. So, it is about this time lag. To add to the correlation point: when CLOs move, I usually say: keep an eye on credit. If credit sells off on a sustained basis for more than a couple of weeks, you reach the area where it feeds through the entire CLO-capital structure. Conversely, this was the case with the AI trade at the beginning of this year.

Jakob von Kalckreuth: The AI trade this year is a good example. Clearly, a lot of people allocated too much money to direct lending as the holy grail – no mark-to-market, high returns. But in the end, returns hardly differ from liquid credit. The capital is locked up, you pay high fees and carry 30% AI risk. That is why people are now queuing up to take their money out of Blue Owl, Ares, BlackRock and so on. The AI trade via direct lending was essentially sold as something “you do not have to think about at night”. One more comment on correlation: there is clearly a correlation between the underlying credit exposure and the tranche exposure. Ultimately, that will benefit the liquid credit markets and hence the tranche markets, because people will no longer allocate nearly as much to direct lending as they did in the past. Tranching is where the arbitrage lies.

Lewis Emmons: It is important to understand that CLOs are risk assets and that they can sell-off and expose clients to mark-to-market risk in negative credit markets – as happened most notably in early 2020 and 2022, when traditional asset class correlations completely broke down. So we have to ensure that our clients understand this risk. That is why correlation is an important point.

Christian Leuchtweis: Investors should also understand the quality and structure of the underlying loan portfolio. At the end of the day, they are exposed to a certain number of loans, perhaps 100 or 200 loans. One should first understand which sectors are included. Is the loan portfolio more exposed to software, AI or cyclical industries? What is the quality of the underlying companies? What allocation or exposure do you have to different regions and potentially to different currencies?

Bálint Vágvölgyi: One should distinguish between two types of correlation. On the one hand, there is credit risk correlation. The financial crisis or the AI-stress would be examples of this. CLO spreads widen in reaction to weakening in the underlying collateral. However, CLOs performed strongly over the cycle. Due to the structural features protecting the rated tranches, the default experience was significantly better than in corporate credit of comparable rating. So, this risk is mostly possible to price in and does not need to impact long term holders. By contrast, when looking at mark-to-market, one must recognise that this is often driven by other factors. In September 2022, we had a completely exogenous situation, a major liquidity event: faced with sharp rise in interest rates UK-based defined-benefit schemes started selling, because they needed cash to meet collateral calls. And they sold the product with the highest cash price: ABS and CLOs, which are floating-rate products. You then get into situations where the logic driving the correlation does not necessarily have to do with the product you are selling. CLOs are part of a broader market, and this kind of correlation will always be there. Nevertheless, CLOs and ABS have always performed very well in stressed markets, demonstrating the underlying liquidity of the market.

Tilo Kraus: I would distinguish between price risk and actual cashflow risk. Focusing on price risk is fine. But we want the invested money back and the cash return. Whether it trades here or there in the meantime is secondary. But I think many investors think somewhat differently about this. They go through the portfolio report to their principals and say: this position is under water; it is at 95. Then the response is: but you said it was a AAA product – how can that be? Part of the problem lies in the understanding.

Ian Bettney: Have you ever had a AAA priced at 95? Perhaps on 30 September 2022 you might have got 95 for selling AAA CLOs. At that time, we were speaking with the regulator about approval for a UCITS-form Luxembourg-based ETF in Europe. That took forever. The regulator wanted data on sales and buyers in the UK and Europe. Only once these data were available was the regulator convinced that liquidity was sufficient.

Jakob von Kalckreuth: A 35-basis-point spread widening or perhaps 40, right?

Ian Bettney: To explain where those market prices came from, you need to adjust the valuation assumptions: wider spreads, higher default expectations, lower call-option value and slower prepayments. Once you factor all of that in, you get much closer to the price the market was efficiently pricing.

Jakob von Kalckreuth: I would like to talk about default rates and the underlying, because that is important. There is a major structural difference between the US and Europe. The LME phenomenon means that US CLO equity has significantly underperformed over the past four years. Particularly in Europe, but also in the US, the structural protections up to BBB remain good even in an environment of rising or persistently elevated default rates. We recently saw a Bain CLO that defaulted at single B in order to be able to liquidate the transaction. Perhaps that is a risk in the CLO space: how do you wind down a deal where the equity is so far under water that it no longer has any skin in the game?

Stamatia Hagenstein: That’s exactly where our consent processes come in. A CLO can only be repaid through the regular call mechanism if every tranche can be paid in full at par. If the proceeds from the portfolio aren’t enough for that, what’s known as a non-par call is required, which needs the consent of the affected tranches, usually the high-yield tranches, i.e. BB or B rated. That’s precisely the moment when managers send our investors in those tranches a consent request. That’s standard market practice and doesn’t yet say anything about the actual repayment: we’re aware of cases where, despite such a request, investors were repaid in full in the end. The lesson: don’t buy high-yield tranches from a manager who doesn’t control the equity.

In your view, what are important aspects in manager selection for CLOs?

Stamatia Hagenstein: When we select a CLO manager, they must first pass our quantitative and qualitative checks. One important criterion for selecting a manager is, of course, the track record: is the manager disciplined enough over the cycle to comply with its tests? After that, we look at the manager’s governance, including ESG requirements. Lupus Alpha has since standardised the questions we send to CLO managers, which we discussed earlier. Before ELFA published its template, we already had more than 130 questions that we sent to managers. These covered topics ranging from due diligence to governance, gender diversity and ESG. It’s also a rule: if there have been legal disputes within the CLO team in the past, we don’t invest.

Bálint Vágvölgyi: It is also important to have a good understanding of the underlying drivers of a manager’s track record. Several well-established, large managers with strong pre-COVID track-records saw their credit performance severely deteriorate post-COVID, especially when interest rates started to rise. For all investors, but especially those lower in the capital structure, it is imperative to know if this was caused by structural factors, like manager style or loss of key personnel, or it was merely the result of a few poorly picked individual loans.

Are there more or fewer asset managers active in the CLO asset class today?

Lewis Emmons: That question is difficult to answer. We see that the provision of CLO opportunities with attractive risk-adjusted relative-value return profiles is coming from different parts of the market. A lot of managers have had the capability to invest in CLOs for a long time but exploited this tactically, e.g. adding securitised and structured credit sleeves to their multi-asset portfolios opportunistically. I do not know whether that is also increasing the number of CLO managers, but I would say that new managers do not simply fall into this credit class. Rather, we are almost always dealing with experienced managers. The CLO market is a highly specialised alternative credit market that requires a high degree of work intensity, many resources and a lot of experience.

Ian Bettney: Here we should differentiate between the US and Europe. Take the development of CLO ETFs. It started in the US. Investors there have a greater risk appetite and are more willing to accept new investment ideas than in Europe. In Europe, we market CLO ETFs more as a market-access product. There, the return profile for AAA CLOs is roughly 90 to 170 basis points over cash. Specifically, that is the ten-year average spread plus or minus one standard deviation. At the point of entry, our clients are therefore buying CLO AAA market beta.

Jakob von Kalckreuth: Market access to CLOs remains difficult for many investors, especially investors in Europe. Perhaps the Solvency II review will soon change something about this situation.

Who will be the main target clients for CLO ETFs in Europe?

Ian Bettney: In principle, any institutional or private investor could be interested in CLO ETFs. We are seeing demand from insurers for segregated accounts. In addition, there are asset managers and wealth managers for private wealth who do not want to build expertise for CLOs in-house. If they want access to CLOs, they generally outsource this to providers. The ETF vehicle also helps some investors gain practical access to this asset class. Banks or treasury functions also want to be able to enter and exit the asset class depending on the bid-offer spread. They use it, as it were, as a cash-plus liquidity bucket.

Stamatia Hagenstein: At Lupus Alpha, we’re currently having intensive internal discussions about expanding our CLO strategy into active UCITS or ETF CLO funds in the AAA/AA rating space, and about building an ETF platform. From a client’s perspective, here’s what I’d find interesting: where exactly does the difference lie between a UCITS ETF with T+1 and a CLO ETF?

Ian Bettney: At its core, the ETF is a UCITS with the same fund-vehicle wrapper from a tax and regulatory perspective. But clients like the execution certainty of being able to enter and exit an ETF quickly, also with regard to the creation and redemption process. The main difference between a fund and an ETF is this: if someone wants to buy a UCITS fund, they have to go through the whole know-your-counterparty process – KYC for short – for identification and verification, speak to the custodian, be onboarded and so on. With a bit of luck, that process takes two to three weeks. By contrast, a wealth manager can buy an ETF very quickly, provided they have the capability and set-up at the desk.

Jakob von Kalckreuth: The CLO market has become much more mature since the dark days of the financial crisis. For example, on Liberation Day, 2 April 2025, I observed some outflows from CLO ETFs in the US. Of course, there were also a few billion dollars behind them, but the number of tranches that had to be sold in order to implement this was absorbed by the market relatively easily. At the time, it became apparent that actual liquidity in the market had become much better than it was during the financial crisis.

What returns can investors expect when investing in CLOs?

Jakob von Kalckreuth: That depends on the tranche. Managers are most strongly aligned with the equity. Typically, managers earn an incentive fee of 20% above a realised IRR hurdle of 10%. A good CLO should generate equity returns of 15% or more across the vintage. If, for example, you priced the deal after the invasion of Ukraine and fixed the liabilities while being able to buy loans at 92, that was a very good return year. In phases of higher volatility or higher default rates, it can be somewhat lower, as we are currently seeing in the US. US returns are currently around 10%. Returns for CLO equity work like this: an investor puts in, say, 100 dollars and receives a return, but never gets the 100 dollars back because the portfolio experiences par erosion over time. Perhaps they get 30, 40, 50 cents on the dollar back, depending on where the deal is called. But the total return of CLO equity as an IRR should be significantly positive. The higher tranches are usually issued as floating-rate products. They are issued at the prevailing clearing spread for that specific risk profile. European AAA tranches are currently priced at 125 over cash. Spreads on AAAs are much wider today than before the financial crisis, and they are wider across the entire structure.

Stamatia Hagenstein: And they remain stubbornly wider, because the investor base for European AAA tranches still isn’t broad enough. A large share ends up staying with the arranging banks themselves, and that limits the competitive pressure that would otherwise drive spreads tighter.

Jakob von Kalckreuth: Yes, as long as supply continues to come to the market. But even in the mezzanine segment, some time ago you could still earn 1,000 basis points of spread, i.e. plus 1,000 for BB risk, 700 over for BBB risk. These spreads have since tightened. The more junior the tranches are, the more volatility is seen in spread and price. That is why timing is so important there. In the senior part of the structure, timing is more relevant for spread duration. For example, if you buy a AAA at 75 over and expect it to be repaid in a spread environment of 125, the equity is incentivised to extend the trade.

Bálint Vágvölgyi: Investors should form their return expectation based on the long-term relative value and volatility of the asset class. Timing is, of course, important, but it is difficult to implement. Typically, the reason why BBBs are trading at 600 is that most investors are not in position to add bonds. Also, CLOs are relatively easily callable, so a BBB bought at 600 is likely to be gone quickly and money will need to be reinvested at tighter spreads. Still, one can say that there are very good times, and there are good times to enter the CLO asset class. The long term structural relative value is always present.

Stamatia Hagenstein: We pay particular attention to the Sharpe ratio. In this context, we regularly show clients a chart plotting the relationship between return and volatility over five or ten years, or even longer periods. The result is clear: over these periods, investment grade CLOs exhibit a return/risk profile comparable to that of corporate high-yield bonds, but with a significantly higher-quality risk profile in rating terms. In our view, anyone specifically targeting equity-like returns should deliberately choose a CLO high-yield strategy instead.

Lewis Emmons: Volatility is indeed a problem for some clients. They would like to hold an exposure to maturity, but for various reasons they may not be able to. Many institutional clients are heavily focused on mark-to-market risk, so the volatility aspect is very relevant there. It can prove a real headache when it comes to short term performance measurement and reporting.

Bálint Vágvölgyi: But that is not specific to CLOs. We like to look at CLO performance using standard deviation, maximum drawdowns or drawdowns above certain thresholds. Post-GFC, CLOs perform well compared to other asset classes in this respect.

Christian Leuchtweis: That is an important part of track analysis. If a potential new investor looks at the different CLO tranches and considers what kind of drawdown or volatility a tranche has over time, it can appropriately assess whether they are able to withstand that volatility or not.

What returns do our investors at the discussion table expect from CLOs?

Tilo Kraus: Numerically, our return expectation aligns with the figures just mentioned, as it roughly corresponds to the market return. What is crucial for us is that we do not need to realise price volatility through forced sales. We therefore focus primarily on cashflow volatility; the option for early liquidation is a secondary consideration. The crucial question is: how high is the cashflow volatility in the end, i.e. the realised return volatility?

Jens Anderson: At R+V, we are targeting the aforementioned 3 percent, which can currently be significantly exceeded with AAA.

What developments do you expect in the CLO market over the medium term?

Bálint Vágvölgyi: We expect continued market growth, supported by increasing demand, albeit possibly at a more measured pace. The spectacular growth rate of the recent years was supported by CLOs increasing their market share in European leveraged loan lending, but that is a finite process. The CLO market cannot be larger than the leveraged-loan market. I also expect regulatory tailwinds to continue. Recent steps are positive, but the regulatory rehabilitation of the asset class has a long way to go. The outlook for the underlying loan market remains volatile given the disruptive influence of artificial intelligence on the entire world. Overall, then, we are very positive on the CLO market. Spreads are in balance and are moving within a range. As long as the arbitrage works, there will be issuance.

Jakob von Kalckreuth: We also take an overall positive view of the asset class. In the medium term, some hot air could come out of the market, because we are definitely seeing too many new managers in Europe and the US, and additional managers are still entering the CLO market. A long line of these managers will never be able to generate positive IRRs for equity with their platforms. Overall, the issuance profile will remain similar to what it is now, while arbitrage could be limited. The question is how much issuance can come at economically feasible terms. Better access for investors is important for the asset class, because CLOs have arrived in the mainstream.

Stamatia Hagenstein: I also expect a constructive development in spreads over the next 18 months, though I wouldn’t call myself unreservedly bullish. An uncertain political and economic environment is meeting historically low spreads. Oil-price swings also feed through into growth. That can quickly translate into volatility. More and more US managers are moving into the European CLO market. That carries risks, but it will probably also lead to clearer differentiation between platforms. Consolidation will inevitably happen as this plays out. It remains to be seen who the winners and losers of that will be in our view, it will be felt most in junior mezz and equity. As for the broader market development over the long term, I expect the European CLO market to remain a growth market and, in line with the loan market, to grow by around 10 percent a year. If anything, we should at some point see genuinely sustainable growth return to Europe.

Tilo Kraus: We expect the underlying leveraged-loan market to limit the growth of the CLO market. That is connected with the underlying private equity market, which is currently not growing because of the massive deal backlog. We also expect recovery rates to fall. That is a function of more asset-light business models. Essentially, there is less hard collateral, and of course loan documentation has become increasingly weaker over the past ten years.

Lewis Emmons: We have an interesting market ahead of us, and one that is ripe for active management. Technical factors are changing significantly, ETFs are developing, and regulation is seemingly moving in the right direction. That should create new and exciting opportunities. At the same time, we are seeing signs of rising defaults, particularly in the lower quality segments of the market. The macroeconomic and geopolitical backdrop is uncertain. We are also seeing a blurring of the lines between public and private markets and a lot of activity at this crossover point e.g. issuers raising debt in private markets and later buying it back by issuing in public markets.

Christian Leuchtweis: I also expect growth in the market in the coming years. One important trend is the movement of the CLO market towards wealth and retail channels. Another trend is manager consolidation: platforms are being merged or bought by established asset managers that do not have their own CLO platform or structure.

Ian Bettney: A further development over the next few years will be the maturation of the investor base as a result of new product types and steadily growing demand. ETFs will not be the sole driver, but I am continually getting to know new groups of clients around the world. One driver will be the global evolution of CLOs into a major asset class. Everyone outside the industry is amazed that there are now more than 1 trillion dollars of assets in CLOs. The development towards a genuine core allocation is the path forward.