Retail Investors Could Soon Dine on Wall Street’s CLO Leftovers

A rare softening in the CLO market underbelly has Wall Street thinking of innovative ways to boost returns.

Demand for collateralized loan obligations — which pool together leveraged loans to large companies — has boomed in recent years as investors sought out higher yields while cheap borrowing costs spurred relentless issuance. But recent global market volatility, as well as uncertainty over the transition away from Libor, have weakened the economics of creating CLOs — with the potential to spur some investors to liquidate their asset pools entirely.

At issue is a pricing discrepancy between CLOs and their underlying loans, with the riskiest portions of some deals, known as the equity tranche, trading below net asset value, or NAV. To unlock value, portfolio managers and their clients may consider splitting open the CLO structures to sell off individual components.

The varying fortunes of the two markets — fully structured CLO deals that are largely still the purview of major institutional investors and leveraged loans where retail has become a much bigger presence — has Wall Street thinking creatively.

Equity investors could “theoretically realize a larger return by selling the loan portfolio, paying down the debt tranches, and keeping the difference than by selling the equity tranche into the secondary market,” Morgan Stanley strategists led by Charlie Wu wrote in a recent report.

The market for leveraged loans remains broadly in rude health as investors seek out a hedge for higher interest rates. Buyers especially in the retail world have been pouring billions of dollars into funds such as the Invesco Senior Loan ETF and the SPDR Blackstone Senior Loan ETF, lured by the promise of floating-rate returns that that will see the interest they earn increase along with benchmark rates.