Focus on inflation, yield-seeking and the reopening trade have driven CLO markets to record volumes.

As investors seek to reduce their rate duration amidst a complex macro picture, we believe CLOs can help address the dual challenges of rate risk and lower yields in broader fixed income. The floating-rate nature of CLOs may prove particularly valuable if the Federal Reserve moves more quickly than expected, for both absolute and relative performance.

Record supply has been a powerful force in the CLO market over the past several months. As CLO spreads were broadly wider in the second half of 2019 and, naturally, for 2020, a large pipeline of CLOs eligible for refinancing built up. This unprecedented amount of refinancing-eligible CLOs has been unlocked as spreads tightened, with 2021 on pace to be the most active year for CLOs. We expect aggregate gross primary CLO supply to be over $300 billion in 2021, surpassing the prior record of $265 billion in 2018. Surges of issuance over the past several months have pressured markets, causing spread levels to widen temporarily at times due to supply/demand imbalances.

After 2020 fundamental performance that, in our view, reinforced the case for the resiliency of CLO structures through challenged markets, demand from longstanding participants and new entrants has continued to pick up. We view leveraged loans, which underly CLOs, as having entered a new credit cycle after defaults in weaker companies were pulled forward to 2020. We expect that leveraged-loan default rates will remain under the long-term averages for the next several years. At the same time, notwithstanding the stellar full-year performance in 2020 as compared to peer asset classes, we have seen that corporate credit expertise and CLO manager selection have become even more important given dispersed performance.

Growth in secondary volumes in 2020 and 2021 suggests that the CLO market continues to mature and be more widely held. Secondary daily trading volumes in below-investment-grade CLO securities is 1.9x higher in 2021 than 2019, and 1.4x higher in 2021 than 2020.

Given that we expect loan markets to remain on a firm footing, that current CLO spread levels are wide of the tights of the past several years—particularly in CLO BB—and that technical pressures could abate in time, we believe CLO performance can continue to be strong for the second half of the year. We view positioning in lower-rated CLO securities as potentially offering the most value in a supportive credit environment, with the possibility of a price return in addition to the attractive carry yield for the rating.