European CLO tranche pricing in the primary market is prone to fluctuations, particularly during periods of economic stress. These fluctuations are influenced by changes in the spreads on loans in the underlying pool and shifts in the supply of and demand for different CLO tranches, which reflects changing investor sentiment and market perceptions of risk.

S&P Global Ratings' analysis reveals that during economic shocks, the coupon margins for investment-grade CLO tranches at issuance are relatively more sensitive than for more junior tranches. The same applies during subsequent periods of economic recovery and during periods of generally heightened demand from investors.

That pattern is supported by long-term pricing data and emerged following the economic shock that began in 2022, which is the most recent event from which European CLO tranche pricing has been gradually recovering. This recovery now appears broadly complete, and in the first quarter of 2025, the pattern of CLO tranche pricing relative to underlying loan spreads had returned to longer-term norms.

These patterns were revealed through our examination of how CLO tranche spreads--and the overall funding cost of CLOs' rated debt--have evolved over time, relative to the spread on the underlying collateral. We previously conducted a similar analysis in 2018 (see "Sharing The Spoils: An Evolution Of European CLO Income Distribution," published April 8, 2018). We provide details of our approach to the data analysis in the appendix of this report.

Average Relative Margin On CLO Liabilities Is At A Three-Year Low

Our analysis incorporates a handful of elements. On the asset side of each CLO, we consider the weighted-average spread (WAS) of the underlying collateral pool as a measure of the regular income that the transaction generates. On the liability side--looking initially at the whole capital structure--we define each CLO's weighted-average cost of debt (WACD) as the average coupon margin across all its rated tranches, weighted by the respective tranches' notional balance at closing. The WACD therefore gives an indication of the overall cost of a CLO structure's rated debt funding, which must be paid from the income generated by the portfolio WAS. We also introduce the concept of "relative margin" (RM), which we define as the liability margin divided by (relative to) the portfolio WAS. This can be calculated at a tranche level (Tranche RM = tranche coupon margin / WAS) or for the whole structure (Overall RM = WACD / WAS).

The average WACD of the CLOs that we rated has varied significantly over the past 12 years, ranging from about 130 basis points (bps) to 330 bps (see chart 1). Average portfolio WAS has proved somewhat less volatile but has also fluctuated. Based on these trends in CLOs' asset and liability pricing, the overall RM has averaged close to 50%, although there have been periods of notable peaks and troughs, which we discuss further below.

Chart 1

An overall RM of 50% can broadly be interpreted as meaning that half of the CLO's portfolio income (in excess of the floating rate index, such as Euribor) is required to cover the coupon margins on the rated debt, leaving half available to cover fees, potentially provide credit enhancement to the rated notes in times of stress if diversion triggers are breached, and generally to provide a return for the CLO equity holders. Periods of lower overall RMs therefore generally mean that more of the income is available for equity holders, and vice versa. That interpretation is, however, an approximation, as the WAS applies to the notional balance of the whole collateral pool, while the WACD only applies to the notional balance of the rated liabilities.

There has also been a correlation between overall RM and CLO issuance volumes (see chart 2). In general, periods of declining RM have coincided with rising issuance and vice versa. This makes sense from both a supply and demand perspective: falling RM may be a symptom of rising demand for CLOs' debt issuance, and the corresponding increase in potential equity returns can incentivize further supply.

Since reaching a post-crisis high, at the end of 2022, European CLOs' average WACD has been steadily declining, and at a faster rate than their WAS. As a result, the average overall RM has also declined. For the CLOs that closed in the first quarter of 2025, the average overall RM was below 50% for the first time in three years, and well below a peak of over 80% at the end of 2022.

Chart 2

Investment-Grade Tranches' Relative Margins Move Most

To better understand the spread dynamics in different portions of the CLO capital structure, we tracked the RM of individual tranches from each rating category. At a tranche level, the RM can be seen as implying each tranche's risk premium (or discount) relative to the risk of owning the underlying portfolio of corporate assets. For example, if a CLO's underlying portfolio of leveraged loans pays a WAS of 400 bps, and the CLO's tranche rated 'BB' pays a coupon margin of 600 bps, then the RM of that tranche is 150%, i.e., its coupons provide a 50% spread premium over an investment in the underlying loan pool. Conversely, a senior 'AAA' tranche will typically have a RM of less than 100% (e.g., 30%), reflecting that its credit risk is lower than the underlying collateral pool, among other factors, and a corresponding spread discount.

The evolution of tranche RMs over time reflects both changes in the overall proportion of CLO pool income that must be used to service rated debt, but also how that income is distributed between investors in different parts of the CLO capital structure. Chart 3 plots the history of average RM at different points in the CLO capital structure for the transactions that we have rated since 2013.

Chart 3

Comparison of the results is made simpler by effectively normalizing the data shown in chart 3. We can do that by rebasing each tranche rating category's average RM relative to its value at the beginning of the data horizon in early 2013 (see chart 4).

Chart 4

Chart 3 shows that speculative-grade CLO tranches are historically priced at a spread premium relative to the underlying collateral pool, i.e., they have typically had a RM of greater than 100%. Conversely, tranches rated 'AAA', 'AA', and 'A' have typically priced with coupon margins lower than the CLO's portfolio WAS. At the bottom end of the investment-grade spectrum, 'BBB'-rated tranches have over time averaged a RM of close to 100%, i.e., they typically price with a similar coupon margin to the underlying collateral WAS.

However, our dataset also highlights that the pricing of investment-grade tranches--in terms of typical RM values--has proved more sensitive to economic shocks, such as the onset of COVID-19 in 2020, and rising inflation and interest rates through 2022. During these periods, CLO tranches rated 'BBB' and 'A' occasionally experienced RMs at premium levels. Since 2022, however, these tranches' RMs have rapidly tightened.

We consider it no surprise that the RMs for investment-grade CLO tranches have recently tightened significantly (and note that this also occurred after the pandemic). From a credit perspective, CLOs have performed well over the years, and they generally continue to offer more attractive yields than many other fixed income products with equivalent ratings, including other structured finance asset classes. In particular, CLO tranches rated 'AAA' have garnered substantial global demand, driven by their appeal as a carry trade, demonstrated secondary market liquidity due to the market's continued maturation, and their function as a cash-park investment. Recently, European CLO tranches rated 'AAA' have also begun to be packaged into exchange-traded funds (ETFs), further expanding their investor base (see "ABS Frontiers: How The Burgeoning CLO ETF Sector Could Impact The Broader CLO Market," published Nov. 26, 2024).

Chart 4 highlights how the RMs of investment-grade and speculative-grade tranches have oscillated between periods of divergence and convergence. The chart also shows the extent to which that happened over three distinct periods, namely:

2015-2017: A new investor base

While the post-2013 CLO market was relatively stable at first, from 2015 we observed a gradual decline in the average overall RM, which eventually reached its lowest-ever level in early 2018. During this period, RMs for investment-grade tranches declined significantly, while the RMs for speculative-grade tranches moved broadly sideways or slightly wider. For investment-grade tranches, this trend took RM values well below their initial 2013 levels, and generally below 100% throughout 2017 and beyond.

We believe RMs' evolution during this period may have been driven by shifts in relative demand for different parts of the capital structure, and changes in perceived risk in underlying loan markets. The divergence between investment-grade and speculative-grade RMs can likely be attributed to Asian investors' debut entry in the market and the fallout from credit shocks in the U.S. that were caused by corporate defaults in the oil and gas sectors. As the post-crisis CLO market matured, the new Asian investor base demonstrated a greater appetite for investment-grade risk and drove up relative demand for those tranches. The corresponding movements in average RMs can thus be seen as a correction in the risk premia for each type of tranche, reflecting both the expansion of the CLO investor base and a maturation of its risk perceptions.

2020-2021: Pandemic-related widening followed by rapid normalization

The onset of COVID-19 caused a sharp widening of investment-grade RMs, with European CLO tranches pricing at their then-widest levels since 2013. The average overall RM reached a high of 64% in the third quarter of 2020, likely due to investors reassessing loss assumptions in the light of the very unfamiliar and uncertain macroeconomic environment.

However, this uptick in RMs proved to be short-lived. By 2021, both investment-grade and speculative-grade pricing had returned to pre-pandemic levels, with the overall RM back down to under 50%, and tranche-level RMs returning to about the same levels as before the pandemic hit.

2022-2025: Rapid move to record wides, followed by gradual recovery

In 2022, mounting macroeconomic challenges marked a significant moment in the evolution of the European CLO market. Renewed inflationary pressures, rapidly rising interest rates, credit risk concerns (e.g., from the war in Ukraine), and uncertainty in global markets sparked the most significant shift in RMs in European CLO history.

Average overall RM rose sharply during the period and reached a new high of 83% in the fourth quarter of 2022 (see chart 1). This would usually suggest intense pressure on the so-called "CLO arbitrage", with the cost of rated debt funding taking significantly more of the structures' regular income stream, leaving less to provide returns for equity holders. However, this period also coincided with low origination volumes of new underlying leveraged financings. As such, CLO managers turned to sourcing collateral from the secondary loan market, often buying loans at a discount to par. While nominal collateral spreads may therefore have been depressed relative to the margins being demanded on CLO tranches, CLO equity holders could eventually have made additional returns from price recovery on the underlying collateral (i.e. returns would have been more heavily weighted towards "pull-to-par"), rather than solely from regular excess spread distributions.

Looking at the tranche level, the RMs on investment-grade tranches during this period were again significantly more sensitive than for speculative-grade tranches, as was the case during the pandemic-related stress of 2020. For example, in the third quarter of 2022, the average RM for 'A'-rated tranches rose to more than 100% (i.e., a premium relative to the underlying collateral) for the first time (see chart 3). On an indexed basis, investment-grade RMs rapidly converged with their speculative-grade counterparts (see chart 4).

There are a few possible explanations for that: First, during this period, investors in junior tranches may have been less likely to adjust their base case loss projections, as higher default rates and potential losses may already have been factored into their assessments. And second, a maturing CLO market provided investors with insights from past stress scenarios, perhaps giving comfort that loss assumptions remain commensurate. During the COVID-19 pandemic, for example, no defaults were incurred on any CLOs that we rated, and we only lowered our ratings on a limited number of junior tranches, demonstrating the asset class's resilience during periods of credit stress (see "COVID-19 Tests The Resilience Of European CLOs In 2020," published Dec. 1, 2020, and "2023 Annual Global Leveraged Loan CLO Default And Rating Transition Study," June 27, 2024).

Since the end of 2022, inflation has slowly moderated, and interest rates have begun to fall. This gradual unwinding of elements of the 2022 economic shock has also been reflected in an equally gradual decline in RM levels across CLOs' capital structures. As of the first quarter of 2025, the average overall RM had fallen back below 50% for the first time in three years.

While there have historically been periods of significant divergence in trend between investment-grade and speculative-grade CLO tranche RMs, they are currently moving lower across all parts of the capital structure. This could signal a return to greater market equilibrium, much like in 2013, when European CLOs re-emerged after the financial crisis.

A Positive Outlook Amid Lingering Uncertainty

We expect the landscape for European CLOs will continue to evolve through 2025, when greater competition and increased investor participation could lead to more balanced pricing across the CLO spectrum. The market's maturation has been characterized by investors' increasingly sophisticated understanding, which in our view has driven greater participation from a broader range of investors, who see CLOs as an attractive asset class to diversify and enhance their portfolios. This growing interest underscores the evolution of CLOs from a niche investment into a more mainstream asset class.

At the end of the first quarter of 2025, European CLO tranches rated 'AAA' were typically pricing at around 120-125 bps, suggesting that a further tightening in RM may be possible. Despite this positive trend, we also acknowledge the wider macroeconomic risks that could affect the market in 2025, including escalating geopolitical tensions and trade wars. These risks could prompt a reassessment of risk among CLO investors, potentially leading to higher RMs should investors feel they deserve a larger share of CLOs' underlying income distributions.

Appendix: Data Approach

• The data in this report is based on European broadly-syndicated loan CLOs that we have rated since 2013.
• We include new issue transactions, as well as refinancings and resets of transactions that were already previously outstanding.
• The analysis presented in this report does not consider the effect of any fixed rate assets or liabilities. In calculating the WACD for CLOs with fixed-rate tranches, we assume such tranches effectively have the same coupon margin as any pari passu floating-rate tranche in the same transaction.
• When considering each CLO's collateral pool WAS, we have taken the WAS presented to us at new issue as indicative.
• Whilst most of the data is based on CLO closing dates, some of the early 2025 data is based on CLO pricing dates (i.e. those CLO transactions which have priced but are yet to close).

Related Research

• ABS Frontiers: How The Burgeoning CLO ETF Sector Could Impact The Broader CLO Market, Nov. 26, 2024
• Default, Transition, And Recovery: 2023 Annual Global Leveraged Loan CLO Default And Rating Transition Study, June 27, 2024
• COVID-19 Tests The Resilience Of European CLOs In 2020, Dec. 1, 2020
• Sharing The Spoils: An Evolution Of European CLO Income Distribution , April 8, 2018