Things are looking up for collateralized loan obligations, or CLOs. A new Moody’s report on the 2025 outlook for CLOs says they’re braced for boosted performance and better chances at refinancing.
According to the report, conditions in the form of collateral defaults are improving in CLO markets due to continued growth and declining interest rates. Speculative-grade defaults are expected to decline over 2025, reaching 2.6% in the U.S. and 2.7% in Europe by next October. That would be a drop from the respective October 2024 rates of 5.6% and 3.3%.
“As competition between broadly syndicated lenders and direct lenders (private credit) intensifies, covenant flexibility and other characteristics typical of broadly syndicated loans (BSLs) will increasingly migrate to private credit,” they wrote.
In the U.S. specifically, Moody’s expects collateral, whether BSL or middle market (companies roughly between $10 million and $1 billion in size), to benefit from a soft landing and interest rate cuts. The soft landing would mean inflation returning to 2%, continued economic growth, and a solid labor market. The interest rate cuts would likely have to continue — something the Federal Reserve isn’t guaranteeing. The combination would mean strong continued refinancing, which would almost by definition reduce collateral defaults.
Leveraged buyout (LBO) borrowers going back to broad syndication are finding it more likely to get a B2 corporate family rating rather than B3 (or equivalents). More leveraged entities are seeing better luck with direct lenders who can fund “very sizeable transactions.” The combination of B2-rated deals and the ability for private credit to fund weaker borrowers will continue to boost the BSL market credit quality through 2025. In 2024, CLOs represented about 74% of the $1.4 trillion institutional leveraged loan market in August 2024. That compares to 71% in August 2023.
The combination of declining defaults, lower interest rates, and falling inflation will create conditions for increased new loan transactions next year. That will be a significant change from 2024 when there was brisk loan refinancing. Reset and straight financing transactions ran to $213 billion through October. About $117 billion in outstanding CLOs will exit non-call periods in 2025. Of them, $94 billion have Aaa spreads above 140 basis points, so good reasons to refinance. However, there was relatively little new loan formation in 2024. That’s equivalent to keeping existing deals out of trouble but not investing in new deals and transactions.