When Things Go Wrong: Risk Across Credit Markets

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Introduction

ADITEE

Good morning and good afternoon to everyone joining us from across the world. Welcome to the Prytania Webinar Series V: When Things Go Wrong: Risk Across Credit Markets, where Savvas Charalambous, Senior Investment Analyst, will be delving into the impact of headwinds and credit stress on CLOs, particularly focusing on what happens to the underlying portfolio of leveraged loans and high-yield bonds, and how this impacts investors across the capital stack in different ways. He will also cover the dynamics of competing investor interests across the CLO capital structure and how these forces can collide or align. Savvas joined Prytania in 2022 and will share his insights drawing from 9 years of experience in the industry. He specializes in CLOs, esoteric ABS as well as private credit.

I am Aditee Mahendra, and I manage the business development and investor relations for Prytania across the UK and Europe. I am joined by my colleague, Angela Lui, who is Managing Director of Business Development at Prytania in the US.

ANGELA

Prytania has been at the forefront of global structured credit since 2003. As a specialist across the full capital structure, we invest in everything from CLOs, ABS, RMBS, and CMBS to esoteric and private credit, with a focus on developed markets—across the US, UK, and Europe.

Our investment philosophy brings together macro insights and bottom-up credit research, underpinned by proprietary systems that allow us to manage risk, monitor liquidity, and move quickly when market dislocations create opportunity. It's this agility and depth of expertise that’s enabled us to navigate multiple credit cycles and continue to deliver for our investors.

The webinar will run for about 30 minutes, and we’d love for this to be an interactive conversation—so please don’t hesitate to share your questions in the Zoom chat throughout the session.

ADITEE

Thank you for joining us today, Savvas.

Macro & Market

ADITEE

To begin the session, when macro conditions deteriorate – slower growth, rising delinquencies – what impact does this have on investors across the CLO capital stack and how are the risks spread across investors in the structure?

SAVVAS

Hi everyone, let’s begin with a quick refresher on CLOs. A Collateralized Loan Obligation is a structured credit product backed by a diversified pool of leveraged loans. These are typically loans made to below-investment-grade companies, and the CLO structure tranches the credit risk into different layers, from AAA down to equity, providing various risk-return profiles for investors.

Now, in terms of the macro environment, we have seen heightened concern around slower global growth, impact of tariffs around the global supply chains, and an uptick in delinquencies across the leveraged loan market. These macro factors impact CLOs differently depending on the tranche seniority.

Higher delinquencies can pressure CLO equity and junior mezzanine tranches more directly. But the benefit of tranching is precisely in how credit risk is distributed. AAA CLOs, for example, have a remarkable track record: even through the Global Financial Crisis, the Oil & Gas/Metals & Mining Crisis, COVID, and the LDI crisis in the UK, historical default rates for AAA tranches were zero.

This protection comes from the subordination beneath them and various structural features we can discuss shortly.

Default & Credit Risk

ANGELA

Thanks, Savvas; that was a helpful overview and a great reminder of how the CLO structure is designed to absorb credit stress at different layers.

Building on that, when markets come under pressure more broadly, whether due to macro shocks or rising defaults, how do CLOs compare to more traditional credit strategies like corporate bonds or leveraged loans, particularly when it comes to risk-adjusted returns and downside resilience?

SAVVAS

CLOs as an asset class currently present one of the more compelling opportunities in the credit markets from a risk-adjusted return perspective.

To fully understand why CLOs may be attractive, let’s first clarify the specific concerns investors currently face. Typically, investors might be worried about either inflation/stagflation or slowing economic activity/defaults.

If the primary concern is inflation or stagflation, perhaps exacerbated by ongoing tariff wars or trade tensions, investors would naturally seek inflation hedges. In such an environment, senior secured loans and CLOs are particularly beneficial because they feature floating-rate coupons, allowing returns to increase in tandem with rising interest rates, thus providing insulation against inflation-induced volatility.

Conversely, if the main worry relates to slowing economic activity or rising defaults, then duration and structural protections become critical considerations. Investment-grade CLO tranches particularly shine in this scenario. They incorporate substantial structural enhancements, such as subordination, overcollateralization, and diversification of collateral pools, which meaningfully mitigate default risk compared to direct investments in corporate bonds or loans.

Across the capital structure, CLOs may offer wider spreads relative to similarly rated fixed-income instruments. For example, AAA CLO tranches currently provide wider spreads compared to U.S. Treasuries, while BB-rated CLO tranches offer significantly higher spreads than direct leveraged loan investments, yet both demonstrate similarly low default probabilities. Investors are effectively compensated for perceived complexity and liquidity concerns, rather than increased default risk.

In the mezzanine space, CLO tranches rated BBB or BB also stack up favorably against traditional leveraged loans and high yield bonds. Unlike direct exposure to high yield or leveraged loans, these CLO tranches benefit from structural safeguards and a broadly diversified collateral base, significantly buffering individual credit events. Thus, during periods of heightened volatility and economic uncertainty, owning CLO tranches collateralized by high yield bonds and leveraged loans may indeed prove both safer and more rewarding than investing in these instruments outright.

In summary, CLOs offer a path for investors to move higher up the credit spectrum without sacrificing yield, underpinned by layers of structural credit enhancement, active portfolio management, and built-in protections against both inflationary pressures and default risks.

ADITEE

As you mentioned earlier, a CLO portfolio comprises of a pool of leveraged loans, so as an investor, why should I invest in CLOs when I can buy the underlying leveraged loans or corporate bonds instead?

SAVVAS

That is a great question. It’s better answered by saying they would experience different returns, with the CLO portfolio benefiting from higher yields and stronger structural credit protections compared to the less protected corporate bond or leveraged loan portfolio, and there are a few reasons why.

When comparing BB rated CLOs and leveraged loans, since 2021, BB-rated CLOs have consistently traded at spreads that are 200 to 400 basis points wider than those of the leveraged loan index. That spread premium is meaningful and it highlights that despite sharing the same underlying assets CLOs continue to offer a more attractive yield profile.

Firstly, CLOs come with built-in structural protections that don’t exist when buying loans outright.

Overcollateralization and interest coverage tests are constantly monitored and if asset performance weakens, these tests kick in automatically to protect the senior tranches of a CLO. These tests are continuously monitored mechanisms and ensure sufficient collateral and income exist to cover obligations, automatically triggering corrective actions such as redirecting cash flows from junior to senior tranches when performance thresholds are breached. That kind of self-correcting structure is not present in most corporate credit instruments.

Secondly, CLO managers operate within strictly defined parameters for selecting assets, limiting their ability to drift into riskier investments. Collateral quality and concentration tests preserve the intended risk profile and usually result in much lower single-name concentration than you would find in a traditional bond or loan fixed income portfolio.

By contrast, traditional corporate bonds or leveraged loans typically have fewer and looser covenants, offering significantly less proactive protection. Covenants in these instruments, when present, tend to be reactive and often provide limited downside protection. Thus, CLOs offer what can be called a self-correcting structure and proactive risk mitigation mechanisms unmatched by traditional credit products, making them particularly attractive in times of market uncertainty.

Lastly, CLOs are floating-rate instruments. This provides a natural hedge against rising interest rates and inflationary pressures.

ADITEE

Building on the scenario of stress in the markets, if credit deterioration or rising defaults occur, how are CLO prices affected? During a flight to safety, how do CLO default rates compare with leveraged loans and corporate credit?

SAVVAS

When credit deterioration or rising defaults occur, CLO prices typically decline, reflecting heightened risk and uncertainty in the underlying loan collateral. However, it's crucial to recognize that this impact varies significantly across individual CLOs based on several key factors, including the manager's quality, portfolio composition, structural protections, and importantly, the CLO’s reinvestment period.

Not all CLOs are affected equally as each CLO has its own unique profile, defined clearly by its offering memorandum, or legal documentation and management strategy. CLOs that have longer reinvestment periods may often benefit from market volatility by purchasing collateral (leveraged loans) at significantly dislocated and discounted prices. This ability to reinvest at advantageous levels can potentially mitigate price declines and improve overall portfolio quality and returns in the medium to long-term.

However, it's important to emphasize the restrictions managers face. CLO managers must strictly adhere to predefined criteria outlined in their documentation such as rating constraints, collateral diversification, and portfolio quality tests. Even if there are attractive opportunities during credit downturns, managers are constrained and cannot freely purchase any distressed or discounted asset that falls outside their specified investment criteria, as this would alter the defined risk profile and potentially breach covenant tests. Moreover, managers need to have not been heavily over-invested or invested in fixed rate bonds (which are typically allowed up to 10% of the portfolio notional) as those assets will drop in value without a corresponding change in credit risk due to the coupon’s fixed rate component.

During market stress periods, such as a flight-to-quality scenario, it's notable that CLO tranches, especially senior rated tranches, historically experience significantly lower default rates compared to the underlying leveraged loan portfolios and corporate credit broadly. This is because structural protections such as overcollateralization tests which provide strong credit enhancement to senior tranches and start amortize those tranches first before any impairment can occur. Over their lifetime, CLOs have consistently outperformed expectations. During the 2007-9 GFC and the 2020 COVID shock, CLO debt tranches posted materially lower default rates than the underlying loan market.

Portfolio Allocation

ANGELA

That’s really helpful, especially the reminder that not all CLOs are created equal and that structure and manager discipline play such a big role in outcomes during times of stress.

So taking a step back to the portfolio level, when credit markets deteriorate, what role can CLOs play in a fixed income allocation overall? Would you say they function more as offense, defense, or both?

SAVVAS

CLOs offer investors an almost surgical approach to risk-return dynamics and the choice is left to the investor whether they want to go the offence and capitalize on increased market volatility or construct a portfolio of defensive assets. Within a broader fixed-income portfolio, CLOs can provide meaningful enhancements in yield, diversification, and risk management, without significantly increasing overall credit exposure. CLOs allow investors from a broad spectrum of risk appetites to participate by using the tranched structure which allows to tailor their investments risk according to their return or liquidity requirements.

Having different tranches allows to target specific risk-return preferences by selecting tranches from AAA-rated senior debt (which offer low risk, lower yield, and higher liquidity) to equity tranches (which exhibit higher risk, higher potential returns, and lower liquidity).

For example, BBB and BB rated CLOs offer attractive yields relative to conventional fixed-income securities like corporate bonds or leveraged loans. These higher yields often result from structural features and diversification, and not from increased credit risk. CLOs have built-in protections such as subordination, overcollateralization, and coverage tests, offering additional layers of security that traditional bonds or direct leveraged loans lack. Moreover, CLOs tranches are floating rate assets which means they are effective hedge against inflation and rising interest rates.

CLOs also offer broad diversification benefits. By holding loans from numerous borrowers across multiple sectors CLOs significantly reduce idiosyncratic risk compared to direct holdings of leveraged loans or individual bonds. Such diversification mitigates the impact of isolated defaults, thereby stabilizing overall portfolio performance.

ANGELA

That’s a great breakdown of how CLOs can be tailored to suit different portfolio objectives and I appreciate the point that the yields investors are accessing aren’t simply a reflection of higher credit risk, but also of structural design and diversification.

Building on that, how do CLO equity and CLO debt actually perform under pressure? And depending on an investor’s risk tolerance, what role should each of these play within a portfolio?

SAVVAS

CLO equity, and CLO debt can be seen as complementary to each other. CLO equity typically targets investors seeking higher returns, as it captures residual cash flows after senior tranches have been paid, offering potential for significant upside if loan performance and market conditions are favorable. This means that returns are theoretically uncapped, with recoveries exceeding 100% of the initial investment. Conversely, CLO debt, especially senior-rated tranches provide a stable, predictable cash flow stream with downside protection and floating rate coupons, appealing to conservative investors who prioritize capital preservation, liquidity, inflation hedge and likely a steady income. Both CLO equity and CLO debt in a portfolio can help investors balance risk and reward depending on their investment requirements.

However, it should be said that during significant market stress the built-in protections in a CLO may likely divert a portion, if not the whole receipts which was due to equity investors, to amortize the capital structure and protect debt investors. In that situation CLO Equity investors will receive a decreased, or if any payment. However, a recovery in the compliance of the tests means that interest receipts will continue flowing from the following quarters.

ADITEE

Picking up on the point you made about liquidity, how is the MTM vol and transparency in CLOs and structured credit in general, compared to other sectors like private credit?

SAVVAS

When comparing mark-to-market volatility and transparency across structured credit (SC) sectors and other segments such as private credit, structured credit generally stands out for its higher degree of transparency and more observable MTM volatility. This is largely driven by the fact that structured credit instruments are typically traded in public markets. They benefit from regular pricing, standardized reporting, and centralized pricing repositories like TRACE in the U.S. These factors contribute to more consistent and timely updates on asset valuations, which allows investors to track market movements closely and respond to changes in real time.

As a result, structured credit may exhibit more apparent volatility, but this is a reflection of its pricing frequency and transparency rather than an inherently riskier profile. The visibility into asset pricing enables better risk management and clearer market signals, which are particularly valuable in times of market uncertainty or stress.

On the other hand, private credit tends to present much less observable volatility. This is not necessarily because the underlying assets are less volatile, but rather due to the infrequent pricing and less transparent valuation methodologies typically used in the private market. Private credit instruments are usually valued on a quarterly basis or even less frequently, often using bespoke models that are not subject to public scrutiny. This lack of regular pricing can mask the true risk in the portfolio and lead to valuation lag, especially during periods of economic downturn or market stress.

While structured credit may appear more volatile on a mark-to-market basis, it offers far superior transparency and price discovery compared to private credit. The perceived stability in private credit can be misleading and may carry hidden risks that only become evident in adverse conditions. Transparency, therefore, should be considered a strength of structured credit, even if it comes with more visibly fluctuating valuations.

ANGELA

That’s a really helpful perspective, especially the point that what may appear as volatility in structured credit is often just a reflection of greater transparency and real-time price discovery, which ultimately allows for more informed and responsive portfolio management.

That brings us to another critical component: active management. From your perspective, when allocating across CLO strategies, what differentiating qualities do we look for in CLO managers? How do you evaluate their ability to navigate different credit cycles, and what are some of the red, amber, and green flags you watch for when assessing manager quality?

SAVVAS

When choosing a CLO manager, several qualities help differentiate between different CLO managers.

First and usually more importantly is a proven track record, demonstrated consistently over multiple credit cycles, highlighting the manager’s ability to navigate periods of market volatility. Importantly, we like to see managers avoid style drift, and a rigorous management of risk buckets, such us the CCC bucket, as both an absolute measure as well relative to the market stays constant and low. Also, equally important is the deep experience in credit analysis, as underwriting and collateral sourcing via a disciplined asset selection directly impacts CLO performance. Firm size and operational capacity also matter significantly as larger managers often benefit from scale efficiencies, a broader sourcing network, and perceived enhanced liquidity in the market.

Moreover, a manager’s ability to regularly launch new CLO deals signals market confidence and long-term viability, from market participants, supported further by stable and committed capital sources that act as a vote of confidence in the platform. Investors frequently categorize CLO managers into different tiers based on these characteristics, recognizing that top-tier managers typically possess strong records, perceived better analytical capabilities, stable and consistent funding bases, which collectively position them to achieve more attractive CLO pricing in the market.

Q&A:

ANGELA

Thanks, Savvas. That’s a great way to wrap up the main discussion, especially your thoughts on how manager quality drives performance in today’s market.

We’ll now move into our Q&A portion, and we’ve received a thoughtful question that ties directly into the themes we’ve been discussing:

What are the key risks and opportunities you’re seeing today in CLO spreads and issuance? And how are managers positioning themselves to take advantage of or defend against those dynamics?

Savvas, over to you.

SAVVAS

The CLO market has demonstrated remarkable resilience in 2025. Following the market disruption caused by the April "Liberation Day" tariffs, which led to a temporary freeze in issuance, activity has rebounded significantly in May. Spreads have compressed to levels which are approaching their February 2025 tights reflecting that investor confidence is still there and demand exists for CLOs.

This resurgence is underpinned by a few factors. Firstly, the perceived de-escalation of the trade war between the U.S. and China has alleviated market fears leading to a tightening of the credit indices both across US and Europe. This improvement in market sentiment has impacted CLO spreads as well, with spreads quickly tightening and managers taking this window of opportunity to resume issuance.

Secondly, the shock was short lived, and while CLOs offer structural subordination protections these were not put to test. However, should the shock have been more severe, these protections would have diverted cash flows away from equity investors to AAA investors.

Now, looking ahead, the outlook for CLO issuance is expected to resume where it left off in March. Following the conclusion of the Creditflux conference in May 2025, the market sentiment was positive and most participants predicted that new issuance volumes in 2025 would continue at a similar pace as pre-“Liberation date” with spreads compressing again back to early 2025 levels. However, it remains difficult to be certain in this current market environment.

Closing

ANGELA

Thank you, Savvas, and thanks to all of you for joining us today.

At Prytania, we remain committed to delivering high-conviction, quality-driven strategies across the full spectrum of structured credit. Whether it's CLOs, ABS, RMBS, CMBS, or more esoteric and private credit opportunities, our goal is to help investors navigate complexity and uncover value across developed markets in the US, UK, and Europe.

We offer access through commingled funds, bespoke managed accounts, and funds of one that are tailored to meet the specific goals of each investor.

A recording of today’s session will be made available on our website and LinkedIn shortly, so feel free to revisit the conversation or share it with colleagues. And if you’d like to explore any of these topics further, you can always reach us at investorrelations@prytania.com.

Thanks again for being with us and we look forward to staying in touch.