Why CLOs are not a canary in the coal mine

Despite the notable improvement in risk sentiment, concerns continue to mount that pressures in the leveraged loan and CLO markets could weaken the ongoing recovery via tighter financial conditions, says Lotfi Karoui  at Goldman Sachs. He says the most frequently encountered concern is that the relative rigidity of CLOs coupled with the strong dependence of leveraged loan issuers on CLO demand, could constrain credit availability. Some observers have also recently grown concerned over the risk that coupon and principal impairments on CLO securities could have systemic ramifications via leveraged losses in the banking system, adds Karoui. Accordingly, he has addressed those concerns in a Q&A format. Karoui says he doesn’t view CLOs – and more generally, leveraged loans – as a source of macro vulnerability, particularly given the healthy dose of policy support that has been injected into credit markets. And while he continues to recommend an underweight allocation on leveraged loans versus HY bonds, the drivers of this recommendation are fundamental in nature and do not reflect concerns over the risk of a systemic shock radiating from CLOs. Within the CLO market, Karoui continues to see value in senior bonds, especially the A-rated part of the capital structure, which he thinks offers an attractive combination of higher carry and low risk of principal write-downs.