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Opinion CLOs
As the US CLO market grows, lower quality loans and increased volatility create new challenges
by Dagmara Michalczuk
Dagmara Michalczuk
Co-chief investment officer
Tetragon Credit Partners
Success in a larger market requires increased discipline and innovation
As we turn the page on summer, it is natural to pause to consider the road US CLOs have travelled thus far. This being my first column, it also seems apt to reflect on the evolution of the asset class over the past 20 years — not as a sentimental walk down memory lane, but as a prologue for understanding my views of the forces shaping the markets today.
Since 2004, the US CLO market has grown 13x to USD 1.1tn, outpacing the broadly syndicated loan (BSL) market, which expanded 11x over the same period, according to Bank of America. I believe CLO creation has outpaced BSL market growth due to the greater availability of long-duration CLO equity capital (primarily ‘captive’ CLO equity funds), the growing use of CLO reset technology, slower recent M&A/LBO issuance, and greater private credit participation.
Why does it matter? Voracious appetite for loans from CLOs has led to a technical imbalance resulting in elevated secondary loan prices and spread compression. While perhaps not a long-term phenomenon, I wonder if recent loan strength is a structural feature of the markets, rather than a reflection of fundamental health. The answer has implications for risk/reward analysis and CLO strategy.
Underwriting demands are rising
I’d like to highlight three key shifts in the US loan market since the 2000s: a lower credit quality mix, the prevalence of covenant-lite structures, and a greater frequency, but shorter duration, of volatility episodes. Collectively, these changes require greater underwriting rigour and a more active style of CLO management.
First, the share of double B-rated loans in the loan index has declined from 49% in 2004 to 24% today, with a corresponding increase in B-rated loans from 29% to 63%, according to PitchBook data. Although partially attributable to shifts in rating methodology, CLOs now face greater sensitivity to negative loan rating migration. This has contributed to increased CLO equity performance dispersion and debt spread tiering, which I believe will continue.
Secondly, covenant-lite syndicated loans have become the norm and have propelled an increase in ‘soft’ defaults via liability management exercises (LMEs), as well as lower recoveries. As of the end of August, the 12-month payment default rate of the US loan index stood at only 1.2%, versus 4.4% when LMEs are included. The lack of maintenance covenants has also removed a catalyst of ‘passive’ loan spread widening. This, along with tighter CLO maturity extension rules, means that CLO managers must now rely on active trading, which increases the importance of their CLOs’ structural health, and their loan portfolio’s value stability.
Finally, 2025 has provided a case study in elevated market volatility. While in the past, risk repricing regimes have tended to span several months, markets are now more reactive, perhaps due, for better or worse, to the willingness of the US Federal Reserve to act decisively when faced with asset price declines.
Volatility cuts both ways
Reactive markets create both challenges and opportunities. On one hand, frequent episodes of risk repricing to take advantage of cheap loan acquisition or CLO liability refinancing may be beneficial for CLO equity investors and managers. On the other, frequent repricings may make loan spreads less ‘sticky’, so managers have to focus on maintaining interest generation.
Spread compression risk also has implications for CLO equity investment timing and duration. While longer reinvestment periods are valuable to CLO equity, the accompanying cost of longer non-call protection cannot be ignored.
Since the start of my career, BSL CLOs have evolved from a niche asset class to one that is well-understood and widely held. They have proven their resilience across credit cycles and successfully responded to shifting regulatory constraints. Nonetheless, experienced CLO investors understand that continued success in a larger, more competitive and volatile market requires increased discipline and innovation. To quote the great ice hockey coach Herb Brooks: “Success is won by those who believe in winning and then prepare for that moment.”