Portfolio Analytics Wrap: Tail Risk Increases in CLO Portfolios Despite Exuberance in Loan Prices

 

Hot on the heels of a record year for issuance, hopes are high among CLO market participants in 2025. Leveraged loans are trading at their highest levels since 2021, according to the Morningstar LSTA Leveraged Loan Index, but some in the market are expressing concerns around mounting tail risk in CLO portfolios that could impair performance of CLOs further down the line.

According to Octus’ Portfolio Analytics data, first lien net leverage among leveraged loans in CLO portfolios rose from 4.11x to 4.16x through 2024 in the U.S. market. In Europe, first lien net leverage rose to 4.94x from 4.72x during the same period across CLO portfolios.

Loan issuers’ interest coverage ratios also reduced during the same period. In the United States, interest coverage fell by 7.17% across the loan universe, from 3.07x to 2.85x, according to Portfolio Analytics data. In Europe, interest coverage declined by 11.08x, from 3.25% to 2.89x.

Erik Miller, partner and co-head of the CLO business at Canyon Partners, told Octus that the CLO market is showing a more complicated set of inputs than has been seen in the last five years.

“The incoming US administration is perceived to be very business friendly but domestically protective, which has driven exuberance for growth prospects and ensured tight spreads on both the asset and liability side,” Miller said.

“In Europe and the rest of the world that policy works in opposition, so you’re starting to see [Purchasing Managers’ Indices] in Europe drop under 50 for the first time in a long time, which is usually a leading indicator of recession-like activity. Where we go from here is going to be dependent on that economic arc that is evident.”

Although leveraged loans remain extremely well-bid, downgrades to triple-C were elevated in 2024 through the end of the year.

Bank of America analysts wrote in a December research paper that net triple-C downgrade volume was $19 billion for the year. While CLOs within their reinvestment period saw their triple-C holdings drop to 5% (well below the 7.5% test limit most CLOs adhere to), the triple-C share in post-reinvestment deals was 10% with 80% of these CLOs breaching their test. Credits downgraded to triple-C in December include Affinity Interactive, Flexsys and Knight Health Holdings.

“We’re at a very tight market on spreads on a historical basis, and you’re not getting paid to take outsized credit risk,” says Brian Yorke, portfolio manager at Muzinich. “Because interest rates are elevated, recovery rates are going to be lower, and because documentation is weaker for the most part and sponsors and other lenders can strip a lot of value from each other, it is better to be cautious when you’re not being paid for the risk.”

The increase in triple-C concentration is partially alleviated by two trends from 2024: private credit refinancing lower-quality, which removes them from the broadly syndicated loan market, and restructurings via liability management transactions.

In a recent research paper, Capra Ibex’s chief credit officer Daniel Miller said that many issuers would have had more serious defaults with material impairments but for the huge volume of LMEs in 2024.

“The LMEs have kicked the can down the road and bought important time for the issuers to take advantage of lowering interest rates coupled with an expected uptick in earnings growth,” Miller wrote, adding that his firm’s base case scenario was that accelerated growth would avert a major default cycle.

“In a scenario of lower growth rates, similar to the past 32 months (or worse), we can expect to see another spike in defaults,” Miller added. “In that case, the likelihood of creditors pursuing another round of LMEs seems unlikely. The more likely outcome would be defaults with more severe impairment because of the additional debt layered on during the 2024 LMEs.”

According to Portfolio Analytics data, revenue growth in CLO assets was 5.44% in the U.S. market last year and 5.14% in the European market. In fourth-quarter reports, revenue growth in the underlying asset pool was 5.11% across the U.S. market and 5.04% in Europe.

Numerous firms outperformed these metrics, with RBC BlueBay, Hayfin Capital Management and New Mountain showing the strongest revenue growth on an asset level in the last quarter of 2024 in the United States, while in Europe Napier Park Global, Pemberton Asset Management and Capital Four claimed the top three spots.

“The CLO market has delivered record levels in 2024 which is testament to the resilience of the CLO model and the increasing confidence of investors,” said Rob Reynolds, head of CLOs at Pemberton. “The metrics relating to underlying borrower performance and leverage are a consequence of the care taken in the asset selection process at Pemberton.”
 

Ranking by annual revenue growth through 2024 showed a similar story. The top performing managers in the United States were RBC BlueBay, Hayfin and Sixth Street Partners, with 9.75%, 9.47% and 9.34% revenue growth, respectively, while in Europe the leading firms were Napier Park, GoldenTree Loan Management and Bridgepoint Credit.

John Murphy, head of syndicated debt at Bridgepoint, told Octus that his firm’s approach focused on the construction of high-quality CLO portfolios that it believes will deliver strong through the performance cycle. “Our approach also positions the portfolios favorably to take advantage of potential market and idiosyncratic dislocation opportunities to further enhance returns,” Murphy said.
 

CLOs in Europe had higher first lien net leverage than those in the United States on average. The ratio averaged 4.97x across European CLO portfolios and 4.2x in the United States, according to Portfolio Analytics data.

Sona Asset Management, Hayfin and GoldenTree had the lowest first lien net leverage in the European market (4.52x, 4.52x and 4.53x, respectively) while in the United States, the firms with the lowest first lien net leverage were Beach Point Capital, Fort Washington Investment Advisors and Whitebox Advisors.
 

By contrast, European CLO portfolio credits had higher levels of interest coverage compared with their U.S. counterparts. The average rate of interest coverage in European CLO loans was 2.87x in the fourth quarter of 2024, while in the United States that figure was 2.83x.

Muzinich, Whitebox and Fort Washington were the three U.S. CLO managers with the highest rates of interest coverage on an asset level, while in Europe, GoldenTree, Canyon and Sona had the highest interest coverage rates at 3.3x, 3.24% and 3.23x, respectively.
 

Muzinich’s Yorke said that his firm runs a conservative strategy, where the weighted average rating factor is kept below 2,400 and triple-Cs are kept below 3% with underweight B3s.

“One of the reasons we’ve seen LMEs increase and portfolios having trouble is because interest coverage is coming down with higher for longer rates, and as interest coverage goes lower, so does liquidity, and therefore you get yourself into trouble,” Yorke said. “By underweighting B3 and triple-Cs and by tasking our analysts to look for weakness in interest coverage, our portfolios have a more stable debt profile.”