Riskiest CLO Funds Flash Warning Sign as Dividends Are Slashed and Share Prices Tumble

Fear of rising defaults in the leveraged loan market is now affecting CLO equity funds, with investors growing cautious about taking on credit risk. Retail funds holding the riskiest parts of collateralized loan obligations are slashing dividends due to falling loan yields and growing anxiety over future defaults. Share prices of several closed-end CLO equity funds, including those backed by the Koch family and Carlyle Group, have reached all-time lows this week.

Publicly listed CLO equity funds represent a small portion of the $1.3 trillion CLO market, but their struggles highlight growing risks being transferred to retail investors. Blue Owl Capital Inc. shares dropped to their lowest level since 2023 after the firm sold $1.4 billion of private credit loans to provide liquidity to retail investors. Analysts at Barclays said some of those loans may flow into CLOs managed by Blue Owl, increasing leverage on the assets.

The pain for CLO equity funds started in the leveraged loan market. Approximately 13% of these loans are tied to software companies, which were once seen as stable borrowers. However, investors are now worried that AI advancements may disrupt software industries by replacing off-the-shelf products with custom-made tools.

Why Did This Happen?

The recent selloff in leveraged loans has amplified concerns about potential losses for mainstream investors. At least three CLO equity funds, including Eagle Point, Oxford Lane, and Sound Point Meridian Capital, have cut their monthly distributions in the past 30 days. Eagle Point Credit Co. reduced its dividend from 14 cents to 6 cents per share.

The CLO market has faced a years-long decline, partly due to a slowdown in corporate mergers limiting the supply of new leveraged loans. As risk premiums shrank, profits for CLO equity investors thinned, and the recent volatility has only worsened the outlook.

How Did Markets React?

Retail investors are reacting by exiting the funds. Share prices of closed-end CLO equity funds fell sharply this week, with some hitting record lows. Eagle Point’s CEO offered a potential solution: if the net asset value keeps declining, the fund will repurchase up to $100 million of its stock.

Captive funds have helped maintain demand in the CLO market despite narrowing yields. About 95% of CLOs now include captive funds, which continue to buy loans even when returns are low. Without these funds, new CLO issuance might have slowed significantly, further eroding returns.

What Are Analysts Watching Next?

The AI-driven disruption in the software industry is a key concern for CLO equity investors. As AI becomes more adept at coding, there is growing uncertainty about the long-term viability of some software companies. This has caused lenders to reassess their risk exposure and reprice loans more aggressively.

Despite the challenges, some analysts see potential opportunities in the current volatility. Ujjaval Desai of Sound Point said the CLO selloff could create a "nice buying opportunity in the secondary market". This would allow CLO equity funds to purchase debt at a discount, potentially improving long-term returns.

The CLO market is also grappling with broader macroeconomic risks. A survey by FTI Consulting found that more than three-quarters of respondents expect loan defaults to rise in 2026. Additionally, nearly 21% of respondents believe an AI investment crash is the most underestimated financial risk for the year.

Lenders remain cautious about the potential for a U.S. recession, with 28% of respondents in the FTI survey believing it is a material or likely risk within the next 12 months. This sentiment reflects a more pessimistic outlook than the previous year.

Market participants are watching how investors react to the current volatility and whether CLO equity can rebound as debt becomes available at attractive discounts. For now, the focus remains on managing risk while seeking long-term gains in a challenging environment.