Riskiest CLO Funds Are Flashing a Warning Sign: Credit Weekly

Fear of rising defaults is spreading from the leveraged loan market to some of the retail funds that ultimately buy the debt as investors get choosier about taking on credit risk.Author of the article:You can save this article by registering for free here. Or sign-in if you have an account.(Bloomberg) — Fear of rising defaults is spreading from the leveraged loan market to some of the retail funds that ultimately buy the debt as investors get choosier about taking on credit risk. Subscribe now to read the latest news in your city and across Canada.Subscribe now to read the latest news in your city and across Canada.Create an account or sign in to continue with your reading experience.Create an account or sign in to continue with your reading experience.The biggest buyers of leveraged loans are money managers that bundle the debt into bonds known as collateralized loan obligations. Some retail funds that buy the riskiest parts of CLOs, known as CLO equity, are slashing their dividends as loan yields fall and anxiety about future defaults mounts. Investors are responding by heading for the exits. Share prices of a handful of closed-end funds, including ones backed by the billionaire Koch family and Carlyle Group Inc., fell to all-time lows this week. Get the latest headlines, breaking news and columns.By signing up you consent to receive the above newsletter from Postmedia Network Inc.A welcome email is on its way. If you don't see it, please check your junk folder.The next issue of Top Stories will soon be in your inbox.We encountered an issue signing you up. Please try againInterested in more newsletters? Browse here.While publicly listed CLO equity funds are a relatively small part of the $1.3 trillion CLO market, they illustrate an issue that’s drawn scrutiny this week: how debts are being sliced up and the risks are transferred to other investors, including retail holders. Shares of Blue Owl Capital Inc., for example, closed at the lowest since 2023 after the firm sold $1.4 billion of private credit loans to offer liquidity to retail investors. Analysts at Barclays on Thursday said that at least some of those loans will probably make their way into CLOs managed by Blue Owl, boosting leverage on the assets. For retail funds holding equity and junior debt from CLOs, the pain started in the leveraged loan market. Somewhere around 13% of those loans are tied to software companies, which were often deemed safe to lend to, because customers make regular payments to them in the form of subscriptions for services. But as AI becomes more adept at coding, investors have grown increasingly alarmed that new tools will custom-make software to replace off-the-shelf products. CLO equity funds were already in a years-long decline before the software rout. While more buyers have flocked to the CLO market, driving up demand, a slowdown in corporate mergers has limited the supply of new leveraged loans. As risk premiums on loans shrank, profits for CLO equity investors have thinned.The recent bout of frenzied selling in leveraged loans has only magnified the potential risk of losses for mainstream investors.At least three CLO equity-tied funds, including ones from Eagle Point, Oxford Lane and Koch Inc.-backed Sound Point Meridian Capital Inc., have cut their monthly shareholder distributions in the past 30 days.

The Carlyle Credit Income Fund, which has held its dividend steady at 10.5 cents per share for nearly two years, is expected to report earnings on Wednesday. Sound Point, Eagle Point and Carlyle declined to comment while Oxford Lane didn’t respond to requests for comment.“These funds do not take cutting the dividend lightly,” said Mickey Schleien, a senior analyst at Clear Street. “Retail investors make up the bulk of their clientele — these folks count on those distributions.”Still, the AI shakeup could be good for CLO investors in the long run. Recent volatility allows investment managers to rejigger their loan portfolios by buying up debt trading at a discount, potentially boosting long-term returns — including for CLO equity.“The CLO selloff could actually create a nice buying opportunity in the secondary market for these CLO equity funds,” Ujjaval Desai, chief executive officer of Sound Point’s fund, told investors on a Feb. 11 earnings call. “It’s much better for CLO equity than the other way around.”Sound Point’s fund lowered its monthly dividend rate by 5 cents to 20 cents per share. Still, other forces have been chipping away at investor profits. The dearth of new leveraged loans has caused yields to narrow, and the firms that manage CLOs have popularized new standalone “captive” funds that buy loans even when profits are slimmer, ensuring demand remains high.About 95% of CLOs are now being issued with captive funds, Desai said. Without captive funds, new CLO issuance would’ve likely slowed, meaning fewer repricings to lower borrowing costs and eat away at profits. But with profits crimped others have also had to slash their dividends, some by more than half.Eagle Point Credit Co., one of the better known funds, dropped its distribution to six cents per share from 14 cents.

But Thomas Majewski, the fund’s chief executive officer, offered investors a solution during a Tuesday call: if the net asset value — a measure of the worth of a fund’s investments — keeps dropping, the fund will buy back as much as $100 million of its own stock under a newly approved repurchase program.Click for a podcast with Acadian Asset Management on quants moving to loans, CLOs Week In ReviewOn the Move—With assistance from James Crombie and Dan Wilchins.Postmedia is committed to maintaining a lively but civil forum for discussion. Please keep comments relevant and respectful. Comments may take up to an hour to appear on the site. You will receive an email if there is a reply to your comment, an update to a thread you follow or if a user you follow comments. Visit our Community Guidelines for more information.