CLO Equity: Where Complexity Meets Opportunity

As advisors seek out differentiated sources of income beyond traditional fixed income, collateralized loan obligation (CLO) equity is emerging as an overlooked source of potential double-digit returns for income-seeking investors. In 2024, the US CLO market hit a record $202 billion in new issue volumes priced, according to Flow, Deutsche Bank’s magazine.¹ This momentum isn’t slowing - BMO Global Asset Management projects that the market will grow by a third, reaching $2 trillion by 2027.² Yet, within this expanding market, it is the equity tranche, which is the first to absorb losses, but also the last to get paid, that offers the highest risk-adjusted upside when managed properly.

CLOs are structured securities backed primarily by pools of senior secured leveraged loans. Originally launched in the 1990s to help banks offload balance sheet risk, CLOs have since evolved, drawing in investors seeking higher yields. Interest surged in the mid-2000s but stalled during the 2008 financial crisis, prompting reforms that improved the asset class’s structure. Still, equity tranches remain underutilized in financial advisor portfolios, given they are often misunderstood or dismissed as too complex and risky for client portfolios.

Much of this caution overlooks how far CLOs have evolved. CLOs’ sensitivity to credit cycles remains a valid concern. If defaults rise within the underlying loan pool, cash flows to junior tranches, particularly equity holders, can be reduced or suspended. Recent headlines like Janus Henderson’s CLO ETF experiencing an outflow of $600 million have also contributed to this trepidation.³

However, CLO equity also benefits from structural safeguards and a dynamic feedback loop that can favor long-term investors. CLOs include mechanisms that push managers to lend more conservatively or halt new loan activity when funding costs rise. Regulatory reforms like the Dodd-Frank Act and Volcker Rule have contributed to improved CLO transparency and risk management. Additionally, a new feature, Applicable Margin Reset (AMR), though not yet widespread, allows interest rates on CLO liabilities to reset via auction. While this primarily impacts debt tranches, it can improve residual cash flows available to equity holders by lowering the overall cost of capital.

Understanding the “waterfall” cash flow structure is crucial. CLOs distribute income from loan repayments through tranches. Senior tranches receive priority payments and offer lower returns; equity tranches are paid last and carry the most risk, but with the potential for returns in the mid-to-high teens, especially in stable or improving credit markets. According to PineBridge Investments, even lower-rated CLO tranches have outperformed high-yield and investment-grade bonds.⁴ Well-selected CLO equity can outperform both, though returns vary significantly depending on the manager’s skill and market cycle positioning.

What truly differentiates CLO equity from other alternative income strategies is the value of manager selection. Advisors must evaluate several key factors: portfolio diversification, manager experience, active vs. passive management, and, importantly, recovery assumptions. CLOs typically offer higher yields due to their complexity and limited accessibility, so a manager’s advantage is their knowledge of the market. Advisors should choose a manager with a track record of performing over cycles and proven loan origination discipline. Equity tranches especially benefit from active management, where managers can opportunistically reinvest cash flows or buy discounted loans during market volatility, capturing upside others miss.

Performance dispersion is significant in CLO equity. A manager assuming 80% recovery on defaulted loans will take vastly different portfolio actions than one assuming only 5%. These differences can have an outsized impact on returns for equity holders, where every basis point of spread matters. For advisors, evaluating these assumptions, and not just headline performance, can be the key to unlocking alpha in client portfolios.

In sum, CLO equity offers a compelling, if complex, opportunity for financial advisors seeking differentiated yield in a relatively insulated structure. While inherent risks like collateral deterioration, defaults and prepayments cannot be ignored, they can be actively mitigated through structure, regulation and experienced management. For clients comfortable with complexity and volatility, CLO equity provides a differentiated alternative income stream, with the potential to significantly enhance portfolio returns when approached thoughtfully.