Jens Vanbrabant, portfolio manager at Wells Fargo Asset Management, says that fiscal and monetary policy is propping up the market indirectly, meaning default rates will be significantly lower than in the last financial crisis, when they reached double digits. This time he expects a default rate of 5-7% over this year and next. “If fewer companies get downgraded to a lower credit rating, and there are fewer defaults, underperforming credits and assets that trade at low prices, that helps CLOs avoid all sorts of problems,” London-based Vanbrabant says. “CLOs are very mechanical in the way they are managed, having to comply with various tests — they’re like supertankers in that you can’t easily reposition them.”

Some CLO investors are betting on a swift rebound of the economy where getting mid to high-teen returns is easy, recalling that transactions done amid the 2008 financial crisis scored some of the highest returns of their careers. But Alberto Thomas, partner at consultancy firm Fideres, describes a ‘state of delusion’, and warns that the real economy is in a significantly worse state than many market participants realise, as companies reach maximum draw downs from revolving credit facilities. “CLO managers and investors think everything will get better because they’ve seen a recovery in the financial markets,” Thomas says. “Markets are not reflecting the reality of the economy — the Fed and the European Central Bank can’t bail out every leveraged loan issuer.” Thomas cautions that defaults announced at the July payment date will be a taster of what’s to come at the end of the third and fourth quarters. “Once you breach your over-collateralisation test, you’re never getting it back,” he says. He adds that while CLOs do not present a systemic risk to the financial system, equity and double B tranches are likely to be “wiped out” by the pandemic crisis, which reflects the structures working as they were intended to do.