Portfolio Analytics Wrap: CLOs With Stronger Credit Fundamentals Present Higher Equity Returns; Active Management Is Key Amid Volatility

Reporting: Sicheng Wan, Chloe Wang

CLOs with higher equity returns showcase stronger credit fundamentals in the underlying leveraged loans, according to a study of Octus’, formerly Reorg’s, Portfolio Analytics data.

CLO equity has performed strongly historically, attracting a diverse investor base that includes asset managers, hedge funds and institutional investors seeking higher returns within the CLO structure. The investor base is evolving to encompass insurance companies and pension funds, alongside typical tranche investors.

Octus analyzed the credit fundamentals of leveraged loans held by 146 U.S. CLO managers and 69 European managers, examining their correlation with equity returns. The data indicates that in both markets, equity returns show a negative correlation with the CLOs’ net leverage and a positive correlation with interest coverage, debt repayment capacity and revenue growth.

Source: Portfolio Analytics by Octus
These correlations align with the market expectations, as higher leverage increases the credit risk and, consequently, the triple-C migration within the underlying portfolio, which could erode the overcollateralization, or OC, cushion, according to Batur Biçer, managing director at Napier Park Global Capital, who invests in CLO equity and junior debt tranches.

“If [credit erosion] causes the OC test to fail, the deal would start diverting cash away from equity. This means that the deal’s equity would underperform,” Biçer told Octus. “The default also means actual par loss in the portfolio, which will reduce the ultimate liquidation value of the equity, another negative outcome for the tranche.”

Octus also analyzed non-credit fundamental metrics at the collateral portfolio level. The analysis reveals a slight positive correlation between equity returns and a CLO’s diversity score and a negative correlation with the weighted average rating factor, or WARF.

The WARF is a numerical measure of the overall credit risk of a CLO portfolio, calculated as the par-weighted average of the credit risk scores assigned to each asset on the basis of its credit rating. Therefore, the portfolio’s WARF is decided by the credit fundamentals collectively, which are ultimately determined by the manager’s credit selection.

“We’re mindful of each credit’s fundamentals but are more focused on the CLO collateral manager’s credit process because CLO portfolios change each month and portfolios are highly diverse,” said Dan Ko, senior principal and portfolio manager at Eagle Point Credit Management. “A portfolio you might like today could look very different next month. We typically do more diligence on the CLO collateral manager and their investment process rather than underwriting every single name in the portfolio.”

Ko added that Eagle Point prioritizes CLO collateral managers who work for equity by being active in managing the portfolio and making relative value swaps. “When we actively engage with CLO collateral managers, we talk through their rationales for holding, selling or potentially buying more of a stressed credit. The key is to keep the stressed credits and the tail risk within the portfolio as low as possible,” Ko said.

Biçer at Napier Park said there isn’t a direct one-to-one correlation between individual loan metrics and CLO equity performance.

“The overall credit fundamentals of the loan portfolio determine the return potential of CLO equity, but it’s more about how managers are managing the portfolio,” Biçer said. “Managers are expected to actively manage the portfolio and monitor the fundamentals, to avoid potential defaults or deterioration in their deals.”

Source: Octus
In addition to the assets, equity returns also depend on the CLO liabilities, given the subordination of the equity and the need for the cash flow waterfall to sequentially follow the priority of payment structure. “If a CLO has an outperforming portfolio but very wide liabilities, the equity returns may still be constrained by the cost of those liabilities,” Biçer said.

Pratik Gupta, head of CLO and RMBS research at Bank of America Merrill Lynch, told Octus that the construction of the CLO portfolio was more impactful than liability pricing on eventual returns to equity.

“The key factor for primary equity returns is the price of loans at the time the deal was issued, not the liability pricing, because once market conditions normalize, liabilities can be restructured at tighter spreads,” Gupta told Octus.

Gupta said that the best performing equity has come from the 2020 vintage of CLOs, and the second strongest performers were from the 2022 and 2023 vintages. These deals priced with historically wide liability spreads but delivered strong returns to equity as managers were able to acquire assets cheaply.

Gupta also noted that the cheap purchase price during a weak market would make equity returns solid, somewhat independent of manager performance. “However, when loans are purchased at more average prices – say, around 98 or 99 – this is where active management becomes crucial,” Gupta said.

Amid the ongoing economic uncertainty following the tariff announcement, Roger Coyle, partner at Fair Oaks Capital, told Octus that the tariff policy would meaningfully increase the U.S. loan default rate and slightly increase default rates in Europe, and that will have negative implications for equity returns.

“You have lower loan prices as a result of the changed economic outlook. So as loan default rates go up, CLOs tend to be able to offset some of the impact by being able to reinvest in loans at lower prices,” Coyle added.

Eagle Point’s Ko said that there are new investors looking at the CLO equity space in the wake of last month’s selloff, but they have not gotten involved because they are priced out, with professional buyers having “a better bid than tourists.”

“All things being equal, the market prefers cleaner portfolios with less stress, but if a CLO collateral manager is too conservative, then there’s not enough cash flow to generate an attractive CLO equity return. CLO collateral managers still need to run a conservative portfolio or one without a tail, but they also need to make sure that the CLO equity payments are strong or else they may struggle to raise equity capital in the future to print more CLOs.”

Biçer at Napier Park said, “A proactive manager can adjust the portfolio to mitigate this risk. We’ve seen managers who actively reduced their exposure to tariff-sensitive sectors have outperformed. We want to work with proactive managers who foresee future volatilities and act, getting out of something after the damage is already done.”

According to Octus’ data, the CLO managers with the highest equity returns on average since inception in the U.S are Silver Point Capital, Benefit Street Partners and GoldenTree Asset Management. In Europe, Serone Capital Management, Cross Ocean Partner and Fidelity have seen the strongest returns to equity.