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.
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.
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 callBloomberg Terminal. "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.
What to Watch
- About $50 billion of US high-grade bond sales are expected in the coming week.
- In Europe, about 55% of professionals surveyed expect more than €30 billion ($35.3 billion) of sales next week.
- In the US, Bloomberg Economics expects an atypically cool US January PPI print given a hotter-than-normal December report. Headline PPI, due Feb. 27, likely rose 0.2% in January (vs. 0.5% prior), with core PPI up 0.3% (vs. 0.7%).
- For an in-depth look at the data and events around the world that could impact markets in the coming week, see the Global Economy Week Ahead from Bloomberg Economics.
Week In Review
- Blue Owl Capital Inc. shares tumbled after a decision to restrict withdrawals from one of its private credit funds raised fresh concern over the risks bubbling under the surface of the $1.8 trillion market. Blue Owl had found four buyers for a $1.4 billion portfolio of loans as part of its plan to return cash to investors in Blue Owl Capital Corp II, including three of North America's biggest pension funds and its own insurance firm.
- Bankers are working on $100 billion of debt tied to leveraged buyouts, with around three-quarters of that underwritten in recent months and in the process of being sold to investors.
- Accounting and advisory firm PIA Group halted a plan to refinance a leveraged loan, amid lingering investor unease about the potential impact of AI-related developments on a swathe of software-dependent industries.
- A lender group led by JPMorgan Chase & Co. is preparing to raise $5.3 billion of debt to support Qualtrics International Inc.'s purchase of health-care survey firm Press Ganey Forsta.
- Equinix Inc. raised $1.5 billion from a two-part US investment-grade dollar bond sale, extending a borrowing wave by firms building infrastructure for the AI boom.
- Crypto lending firm Ledn sold $188 million of securitized bonds backed by Bitcoin, making it the first ever deal of its kind in the market for asset-backed debt.
- Banks are pitching cheaper, more creative credit hedges to persuade investors to buy protection after a year in which traditional hedging trades looked like a waste of money.
- A $330 million leveraged loan to two units of methanol maker Consolidated Energy Ltd. is being marketed at what would be the biggest discount in over two years.
- Bank of Ireland Group Plc is withdrawing from the US market for leveraged acquisition financings as private credit has started to chip away at fees historically collected by traditional banks.
- Multi-Color's unsecured creditors are fighting back against Clayton Dubilier & Rice's attempt to maintain control through bankruptcy, challenging the company's $250 million bankruptcy loan and venue selection in New Jersey.
- AMC Entertainment Holdings Inc. is seeking nearly $2.5 billion from credit investors to refinance existing debt.
- Vanderbilt Minerals filed for bankruptcy after its cash flow was overwhelmed by an increase in lawsuits that accuse the company of once selling items contaminated by asbestos.
- Altice USA Inc.'s lawsuit against lenders including Apollo Capital Management, BlackRock Financial Management and Oaktree Capital Management will proceed while a federal judge considers a request to throw out the case.
On the Move
- JPMorgan Chase & Co. named Catherine O'Donnell as its head of leveraged finance for North America. O'Donnell will move to New York from San Francisco and report to the bank's global head of capital markets Kevin Foley.
- Michael Banchik, who was HSBC Holdings Plc's global head of structured syndicate, has left after more than two decades at the bank. He is set to launch a private equity business with partners in Asia and North America.
- HSBC cut 10% of its US-based debt capital markets team, continuing to cull costs after announcing a revamp of the business last October. At least six people in New York were let go Thursday.
- Japanese lender SMBC Nikko Securities America Inc. hired investment-grade bond trader Andrew Padula from Deutsche Bank AG, and is planning to bolster its bench of trading talent with more hires.