LONDON: Returns on the riskiest portion of collateralised loan obligations (CLOs) are booming, reaching about 20% annualised on both sides of the Atlantic as loan performance improves, debt spreads tighten and payouts grow.

In some cases, a structural quirk that’s allowed managers to put fresh debt on old deals has also aided returns to the equity slice, the first piece of the structure that takes losses.

Money managers that put together CLOs - bonds backed by a group of leveraged loans - are taking advantage of falling fundings costs and issuing more lower-rated bonds, instead of hanging onto them.

Many are now selling what’s known as a “deferred class F tranche,” tacking it on to an older CLO. The money they get from the sales can reward equity holders with fresh distributions.

“Managers are able to flush the sale proceeds straight out to equity, which can lead to bumper returns,” said James Baillie, a structured credit partner at Paul Hastings in London.

The deferred tranches are another example of how issuers are taking advantage of a strong rally in risky debt as fears of a recession recede and pricing recovers after a prolonged rocky period. Since the start of the year, more than a dozen such deals have been issued in Europe from CLO managers including Invesco and Capital Four.

Equity returns have also been helped by a number of CLOs exiting their non-call period, meaning they can be refinanced, restarted or liquidated.

The new pricing and extended investment timelines can also free up more cash that can be sent to the equity portion, Baillie added.

“In both approaches you’re moving from a less levered to a more levered position and that’s giving you in some instances an equity dividend,” he said.

CLO equity returns have been choppy in recent years due to fluctuating arbitrage - or the difference between the yields a manager gets from the loans it buys and the funding costs on the bonds it issues.

After falling in 2023, European arbitrage levels have stabilised this year at around 200 basis points, and recently started rising marginally, according to Bloomberg Intelligence.

“In 2022 and 2023, spreads were wider on both assets and liabilities which made placing third-party CLO equity more challenging,” Ben Hunsaker, a portfolio manager at Beach Point Capital Management, said of the US market.

He said those deals have likely since experienced strong equity payments and should be able to refinance their liabilities when their non-call periods end.

 - Bloomberg