Bringing You CLOser – An Insightful CLO Q&A

The US institutional leveraged loan market is approximately US$1.5 trillion, while the US CLO market outstanding is approximately US$1 trillion, representing roughly 65% of the leveraged loan market size. CLOs have solidified their dominant role as the primary buyer of leveraged loans, with the growth of each market since the Great Financial Crisis being strongly correlated to one another.

Growth for loans and CLOs was muted in 2025, but focused on refinancing activity, keeping loans and CLOs outstanding in both markets, with lower costs. As we look for growth into 2026, there is room for both markets to continue to expand at a modest rate. Loan volume will be dependent on leveraged buyout and M&A financing needs, as well as the continued demand from CLOs as the majority buyer.

At the time of writing, the current arb between CLO debt and loan spreads is very compressed. Not only is this putting pressure on new issue CLO equity returns, but also existing CLOs that have portfolio loan spreads continuing to decline with CLO debt costs that are still expensive and within their non-call period. As the CLO and loan markets tightened through the second half of 2025, we saw an increased focus on CLO refinancings, but new issue CLOs kept pace with the loan market, with CLOs continuing to be the owner of approximately 65% of the loan market. CLOs issued in early 2024 during a period of market volatility took advantage of attractive loan prices, but CLO debt costs were also wide and expensive. These CLOs are now coming out of their two-year non-call period in 2026, and managers will be highly motivated to refinance these CLOs to improve the CLO arb. In the first half of 2026, we expect a large portion of CLO volume to come from refinancings and resets, though CLO new issuance will not halt.

Yes, there is value to pricing CLOs when the cost of CLO debt is at historically tight levels, as we are currently seeing. The value captured is being able to “lock” in debt spreads for at least two years and have a loan portfolio that will be able to take advantage of future volatility, which would improve future arbitrage and CLO performance over its five-year reinvestment period. The two ends of the CLO opportunity spectrum are either 1) wide loan spreads and wide CLO spreads, taking advantage of an attractive current portfolio opportunity at a higher financing cost, or 2) tight loan spreads and tight CLO spreads, taking advantage of an attractive financing opportunity but expecting to capitalise on attractive portfolio opportunity in the future. We have seen CLOs be able to generate attractive CLO equity IRRs from each opportunity, and opportunities in between, which will continue to support CLO new issue volume. This current environment is similar to the spread environment in 2018, where arb tightened and spreads compressed. CLOs issued in 2018 were able to continue to reinvest through the market volatility of COVID and the early stages of the Russia/Ukraine conflict only exiting reinvestment in 2023, though many 2018 vintage CLOs have been reset or refinanced.

Even in periods of tight arb environments, we have seen short bouts of loan volatility that CLO managers try to use as buying opportunities. In 2025, the US Tariff “Liberation Day” saw loans trade down several points, widening the arb temporarily. In 2026, AI fears in early February saw volatility in software led loans to trade down as CLO managers reduced technology exposure and rotated portfolios into other sectors. While we would consider both years to be mostly tight arb environments, we do not expect it to be without opportunity.

The ultimate impact depends heavily on where rates and spreads are moving. Base rates falling due to US Federal Reserve easing in response to controlled inflation is very different from rates falling due to economic crisis. Similarly, spreads tightening due to strong corporate fundamentals differs substantially from spread compression driven by CLO demand or search-for-yield behaviour. Lower all-in borrowing costs provide significant relief for loan issuers. When both the base rate (SOFR) and the credit spread compress, borrowers benefit from reduced interest expenses. This improves cash flow, enhances debt servicing capacity, and can strengthen balance sheets. Companies facing near-term refinancing can lock in more favourable terms, potentially extending maturities at lower costs. We expect a reduction in defaults and liability management exercises (“LME”) in the short term.

Companies that were on the edge can often survive longer, pushing out restructuring timelines. Although weaker credits may have been able to refinance cheaply, we may see a buildup of vulnerable borrowers who remain solvent only due to favourable financing conditions. When conditions eventually normalise or deteriorate, defaults could spike more sharply than historical patterns would suggest. The impact varies significantly by credit quality. Strong borrowers benefit unambiguously, while weaker credits may simply be extending their runway without addressing fundamental operational challenges. Fundamental credit analysis and active portfolio trading will continue to be important as CLO managers focus on avoiding defaults and retaining principal value.

Captive funds play a significant and growing role in CLO new issuance, serving as important demand anchors in today’s market. We have seen a noticeable rise in popularity, and in 2025 captive funds were the equity source for as much as 80% of CLO new issue volume. Captive funds’ success is a result of many factors, but notably 1) exclusive access to a managers’ majority CLO equity, 2) a tangible CLO issuance pipeline, and 3) the ability to buy loans and print CLOs quickly in periods of opportunity.

1. Managers who have moved to captive strategies may offer fund investors exclusive exposure to majority CLO equity. Investors in captive strategies may be drawn to these funds for their access to managers with a strong track record, exclusive exposure to majority equity of that manager, and competitive fees vs third-party equity strategies. Captive funds holding majority equity may also be solving for EU Risk Retention requirements, expanding their investor base in Europe.
2. CLO managers with captive strategies are able to more certainly layout future CLO issuance based on the captive capital available. CLO debt investors frequently ask managers their thoughts on future CLO issuance and pipeline. While this is not a firm commitment from the manager, having captive capital available gives a higher degree of certainty to issuance compared to individual third-party CLO equity. CLO debt investors, when looking at managers to underwrite and approve, may look favourably on a manager that will bring consistent issuance and more opportunities to invest after the underwriting is completed.
3. Captive funds provide a crucial commitment during the CLO formation process. CLO managers with strong captive support can move more quickly from mandate to market, giving them a competitive advantage in securing attractive loan collateral when spreads are favourable.

At the time of writing in March 2026, we expect the first half of 2026 to continue with record levels of refinancing and reset activity, with a large portion of refinancings coming from CLOs issued in early 2024 with expensive financing costs. These CLOs will be highly motivated to reduce these costs and reset the CLO arb more favourably. While 2025 saw little CLO debt cost differentiation between new issues and resets, we believe that CLO debt investors will demand a higher risk premium for reset CLOs this year compared to new issues. Reset portfolios being older, may have more loans trading at discounts compared to a clean new issue portfolio that was purchased after the AI fear volatility in February. With a potential material difference in portfolio price and market value over-collateralisation (MVOC) between resets and new issue, CLO managers may look to clean up reset portfolios to make statistics look similar to those of new issue. In doing this, loans that are pricing in stressed levels, as well as CAA / CCC-rated loans may be reduced and sold. We expect this trend of selling risk to optimise reset metrics may continue through 2026.