Concerns are mounting over rising default rates, extending from the leveraged loan market to some retail funds that ultimately purchase this debt, as investors become increasingly selective about taking on credit risk.
The largest buyers of leveraged loans are asset managers who bundle these debts into debt instruments known as collateralized loan obligations (CLOs). Some retail funds investing in the higher-risk tranches of these instruments – known as CLO equity – have begun reducing their distributions, as loan returns decline and worries about future defaults increase.
Investors have responded by heading for the exits. Shares of several closed-end funds, including those backed by the billionaire Koch family and Carlyle Group, hit all-time lows this week.
While exchange-listed CLO equity funds represent a relatively small portion of the $1.3 trillion CLO market, they highlight an issue that came under scrutiny this week: how debt is sliced and diced and the risk transferred to other investors, including individuals.
For example, shares of Blue Owl Capital closed at their lowest level since 2023 after the firm sold $1.4 billion in private credit loans to provide liquidity for individual investors. Analysts at Barclays on Thursday suggested that a portion of those loans could end up within CLO structures managed by Blue Owl, increasing leverage on those assets.
The pain in the leveraged loan market is beginning to be felt by retail funds holding junior debt and equity from CLO structures. Approximately 13% of these loans are linked to software companies, which had largely been considered safe lending candidates due to their reliance on regular subscription payments from customers. However, with the increasing ability of artificial intelligence to write code, investor fears are growing that latest tools will lead to the development of custom software that replaces off-the-shelf products.
CLO equity funds had already been experiencing a steady decline for years before the recent downturn in the software sector. As more buyers entered the CLO market, boosting demand, a slowdown in mergers and acquisitions reduced the supply of new leveraged loans. As risk premiums on these loans narrowed, returns for CLO equity investors declined.
The recent sell-off in leveraged loans has only amplified the potential for losses for investors.
At least three funds linked to CLO equity, including those affiliated with EaglePoint, Oxford Lane, and Sound Point Meridian Capital – backed by Koch – have reduced their monthly distributions to shareholders in the past 30 days. Carlyle Credit Income Fund, which has maintained its distribution at 10.5 cents per share for nearly two years, is expected to report its results on Wednesday.
Sound Point, EaglePoint, and Carlyle declined to comment, while Oxford Lane did not respond to requests for comment. “These funds don’t take distribution cuts lightly,” said Mickey Schlain, a senior analyst at Clear Street. “Individual investors make up the bulk of their clientele, and those investors rely on those distributions.”
However, the shift brought about by artificial intelligence could prove positive for CLO investors in the long run. The recent volatility allows investment managers to reshape their loan portfolios by purchasing discounted debt, which could boost long-term returns, including those from CLO equity.
“The sale of CLOs may create a good buying opportunity in the secondary market for CLO equity funds, which is much better for CLO equity than the alternative,” Sound Point CEO Ogawa Desai told investors during an earnings call on February 11. Sound Point reduced its monthly distribution rate by 5 cents to 20 cents per share.
However, other factors continue to erode investor returns. A shortage of new leveraged loans has narrowed yields, and companies managing CLO structures have launched new, independent “captive” funds that purchase loans even when returns are lower, in an effort to maintain demand.
Desai noted that approximately 95% of CLO issuances are currently done through captive funds. Without these funds, new debt issuance of this type would likely slow, meaning fewer opportunities to reprice and lower borrowing costs. But as returns decline, others have also been forced to cut distributions, some by more than half.
EaglePoint Credit, a well-known fund, reduced its distribution to six cents per share from 14 cents. However, CEO Thomas Majewski offered investors a solution during Tuesday’s earnings call, stating that if the net asset value – a measure of the fund’s investment value – continues to decline, the fund will repurchase up to $100 million of its shares under a recently approved buyback program.
