Riskiest CLO Funds Are Flashing a Warning Sign: Credit Weekly

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(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. 

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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. 

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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. 

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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. 

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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. 

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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. 

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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.

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The recent bout of frenzied selling in leveraged loans has only magnified the potential risk of losses for mainstream investors.

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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. 

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Sound Point, Eagle Point and Carlyle declined to comment while Oxford Lane didn’t respond to requests for comment.

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“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.”