Challenged arbitrage and barbells in CLOs

Find out where the CLO market is headed next. Matt Maggio of RBC BlueBay discusses today's challenged arbitrage and shifting investor dynamics and why an expected late-2026 M&A rebound could unlock fresh opportunity for CLOs.

Today's CLO market and its key participants

We haven't seen a significant change in who is buying what, so there's no major shift on that front. On the manager side, the firms most active in CLO issuance are those with captive equity funds from limited partners.

We've seen a good number of called deals because, given the challenged arbitrage and NAV relative to where CLO equity currently trades, it is sometimes more valuable to call a deal than to refinance or reset it. By contrast, new issuance volumes are down around 25% year to date. As deals are called, that supply returns to the market and continues to put pressure on names that investors are less comfortable with from a credit perspective. This is creating a barbell effect in the current market.

What LPs fear about CLOs, and what keeps them invested

LPs are starting to see investments that were pitched at mid- to high-teen return levels delivering much less than that. As a result, we've seen a slowdown in new issuance, largely because LPs are hitting the brakes.

On the positive side, what encourages LPs to keep investing is, in part, the fact that the underlying credit landscape in the US is fairly strong.

What's more, if you look at where their dollars are going, many LPs have been pushed toward private credit in recent years. Now, because of the lack of trading in private credit, valuations are largely at the manager's discretion, and concerns are growing about those allocations. Because CLOs provide a much larger, diversified pool of private assets, plus transparency through the vast amount of data available, a shift is taking place.

That transparency is a differentiator for the CLO market that investors appreciate. Those who have been burned a bit in private credit are now moving into public markets, and I would include CLOs as more of a public investment.

CLO performance versus benchmarks

Some of the best-performing asset classes over the past 24 months have been CLO tranches—not necessarily equity, but more AAAs and BBBs. We've been particularly focused there, with BBBs representing the sweet spot.

These tranches have outperformed the equity side, which has contributed to the difficult equity arbitrage, since liabilities remain wide relative to where the underlying assets are priced. Given that, you would expect the tranches to outperform, as they offer wider spreads for the risk you take.

Concentration-risk fears: justified or ill-founded?

CLOs offer available diversity scores, which give investors a way to identify concentrated portfolios. The fears are specifically within the software and AI-related sectors, and if you look at the CLO market broadly, we have been underweight in those areas. Market exposure sits at about 11–12%, while RBC BlueBay is closer to 7–8%.

One major problem is the names in those sectors are quite large, so bigger managers hold outsized positions they can’t easily exit without significantly impacting secondary pricing. That means some investors get stuck with chunky, oversized positions. There are also concerns that large defaults in those sectors could have a spillover effect on the rest of the market.

The other side of the equation is private credit, where some panic-selling situations have involved meaningful software positions. In certain funds, concentration in software and AI-related companies reached as high as 40%, which drove demand for withdrawals and, in turn, limitations on distributions.

In the public broadly syndicated loan market, we're now seeing quality private credit loans originated roughly two years ago coming back to the CLO market, pushing out maturities and saving on interest costs. However, as quality names leave the private credit space, the concentration of lower-quality names has become a larger proportion of those funds, which means they risk getting stuck with low-quality credits.

The final issue with private credit is that quality loans are trading at or above par, while software and AI-related baskets are trading in the low 90s. As a result, the weighted average price of the loan index sits somewhere around 97, but that figure is misleading and disguises the reality of the barbell picture.

The CLO wave from US to Europe

That wave has slowed a bit. For most of the last few years, the arbitrage in Europe was typically better than in the US. Europe's smaller market meant higher coupons, and portfolio concentrations tended to be larger, while loan liquidity was also lower.

However, we're now seeing a compression of spreads, with US and Euro CLOs trading almost flat, so that trade is largely over.

12-month outlook: CLOs of the future

We're fairly bullish on the outlook from here, given we expect a decent pickup in M&A through Q3 and Q4. With Iran and other disruptions, the first half of 2026 saw many auctions put on hold, and supply has been pushed to the back half of the year. Right now, we're supply-constrained, but more supply will help widen underlying credit spreads. That in turn will help the equity arbitrage.

Over the last two or three years, there has been minimal net new issuance. Private equity sponsors have a lot of dry powder, and the main gating issue has been interest rates. Now that those elevated rates look set to last, we expect bid-ask spreads to reconfigure, based on a new appreciation of realistic debt costs. I expect activity to increase somewhat over the next 12 months.

As for the CLOs of the future, people are always looking at ways to maneuver within the structures. We've seen fixed senior equity come to market, adding a single B-type slice into the funds and increasing leverage. But from a typical structuring perspective, things have been largely the same for a long time. This product is one of the few that has been remarkably resilient through the global financial crisis, COVID-19, and other disruptions, and in our view, that will continue.

What we expect to change the most moving forward is the concentration in underlying risk assets that come to market. That is likely to be a function of equity market valuations, M&A, and other broader factors. The structures are unlikely to change, but the concentration of what sits within those structures is what we expect to define the CLOs of the future.