“CLOs Are Having a Moment”: Q&A with Palmer Square’s Taylor Moore 

With the current macroeconomic environment, especially in the context of still elevated interest rates and inflation concerns, collateralized loan obligations (CLOs) remain an attractive asset class, particularly due to their floating-rate nature. However, the risks, especially related to defaults and credit quality in the lower tranches, should not be underestimated. 

The CLO market itself has been growing rapidly in recent years, with new CLO issuance hitting record levels. This growth is partly due to the favorable conditions for leveraged loans and the demand for structured credit products. As more CLOs are issued, more CLO ETFs are being launched to meet the demand for investment in these products. 

Taylor Moore, managing director and portfolio manager at Palmer Square Capital Management, a credit-focused asset manager and global CLO issuer with $33 billion in assets under management, expressed his views about the strong institutional and retail investor demand for CLO ETFs, including attractive yield and diversification benefits. He also discussed the current rate cycle and concerns over increasing corporate defaults. 

With offices in Kansas City and London, Palmer Square is planning to launch three ETFs early this year for European institutional investors, which will include an active multi-strategy ETF providing similar exposure to PSQO, its ETF currently offered in the US. Two of the ETFs will be passively focused on EUR and USD denominated AAA and AA CLO debt. 

CM: What has been driving robust demand for CLO ETFs in recent years, and do you expect it to continue? 

TM: Attractive yield in a higher-for-longer environment – As we’ve maintained for the last couple of years, our view is that rates are likely to remain “higher for longer” and the market’s expectations for additional rates cuts is likely to prove too optimistic – especially if U.S. economic growth remains resilient like we expect. 

• We think CLO equity and debt remain the optimal place within the credit landscape, with both directly benefiting from a high-growth, high-rate outlook. 

• We are constructive on CLO debt given moderate growth expectations and inflation continuing to be sticky, which should benefit floating rate products in general. Spreads across the CLO debt stack are still wide compared to other areas of fixed income. 

Increased market access via ETFs – ETFs democratize access to CLOs, which traditionally required significant capital and expertise. The introduction of ETFs focused on CLOs has improved accessibility, transparency, and liquidity in a market traditionally dominated by institutional investors. This has attracted retail investors and smaller institutions. 

Strong credit performance – Fundamentals remain steady as defaults have moderated from 2022-2023 highs, growth + lower base rates should continue to support a lower default rate going forward. 

• S&P rated U.S. CLOs have a 0.32% default rate. 40 of the 60 U.S. CLO tranche defaults were from pre-2009 CLOs. S&P rated European CLOs have a 0.41% default rate. All European CLO tranche defaults were from pre-2009 CLOs. 

Diversification benefits – CLOs pool loans from a variety of industries and borrowers, offering investors exposure to diversified credit risk. This is one of the reasons CLOs are having a moment right now, as investors are looking to find savvier ways to “optimize the 40” in their portfolios.  
 
CM: What is your outlook on the current rate cycle and how it may affect CLO assets as well as underlying borrowers’ loans? 

TM: Impact on CLO assets 

• Floating rates continue to be an attractive relative value play: Although the forthcoming Fed rate cut cycle is set to erode some of the current income advantage offered by floating rate products, we believe floating rate / low duration credit continues to present an attractive opportunity. 

In the CLO market, 2025 new issue volumes will exceed the prior high-water mark of $185 billion in 2021, which is on track for more than $200 billion. Add on top of that another more than $250 billion of refi/resets and 2025 will be the busiest year on record by far. 

• Corporate fundamentals stabilizing: In the third quarter of 2024, revenue from investment grade issuers returned to positive year-over-year growth for the first time since the third quarter of 2023 and EBITDA (earnings before interest, taxes, depreciation and amortization) growth turned positive after five quarters of consecutive year-over-year declines. 

Impact on underlying borrowers 

• Improved interest coverage for borrowers – Loan borrowers directly benefit from the 100 basis points of Fed rate cuts in 2024 given they float on 3-month SOFR, which improves interest coverage and cashflow at the borrower level. Combined with our growth outlook of 2% to 3%, we expect defaults and CCCs to trend lower in 2025, which will positively impact CLO equity. 

• Increased debt servicing costs – Borrowers in leveraged loan markets are facing higher interest expenses due to rising rates. This can put pressure on companies with weaker balance sheets, potentially leading to increased defaults in certain segments. 

• Refinancing challenges – Higher rates can make it more expensive for borrowers to refinance existing debt, especially for firms with near-term maturities.  

CLOs are likely to remain resilient, particularly senior tranches, given their structural protections and diversification. However, investors should closely monitor: 

• Default rates in leveraged loans. 

• Economic growth trends, as these affect borrowers’ ability to service debt. 

• Spread movements, as they influence CLO valuation and attractiveness. 

CM: Do you have concerns over increasing corporate defaults and their effects on the CLO market? 

Increasing corporate defaults pose some risks to the CLO market, though the impact varies across different tranches due to the structural protections embedded in CLOs. Current default rates remain well below levels needed to broadly impact rated debt within a CLO. 

Returns in the loan market were entirely driven by interest return in 2024, and while base rates have declined after the Federal Reserve initiated its first interest rate cut in September, yields remain attractive relative to history, and thus loan demand remains high across institutional and retail investors. 

Senior tranches are well-protected due to their priority in the payment waterfall structure and significant credit enhancement. Even in stressed scenarios, defaults would need to reach extremely high levels and remain there for an extended period of time to erode protections for these tranches.