CLOs Uncovered

Looming Loan Losses

Today’s pressure on mezzanine and equity tranches reflects a multi-year accumulation of credit stress, now compounded by sector disruption tied to AI. Portfolios largely constructed during the 2013–2020 period of low defaults have been extended through resets and refinancings, preserving exposure to increasingly levered credits. As conditions tightened, stress emerged through both traditional defaults and liability management exercises, eroding recoveries and gradually compressing Market Value Overcollateralization (MVOC).¹

AI-driven disruption, particularly in software and adjacent sectors, has accelerated this trend (as discussed here in The Case of AI Disruption and CLO Dispersion). Average MVOCs for BB rated tranches have declined to roughly 105%, leaving limited cushion before impairment thresholds (Exhibit 1).

Exhibit 1

U.S. Mezzanine Tranches Show Thinning Impairment Cushion

While headline levels appear manageable (near long-term averages), they mask growing dispersion: a subset of portfolios, particularly those concentrated in stressed sectors, are already operating with minimal protection. As dispersion widens, even modest loan price declines can disproportionately impact these portfolios, accelerating the erosion of expected principal recovery for mezzanine investors.

Realized Outcomes

What was previously a forward-looking concern is now translating into realized outcomes. Nearly a third of BB tranches have limited or no impairment cushion, with approximately 23% below 3% and 7% already uncovered. These dynamics are most pronounced in amortizing deals, where seasoning and cumulative net losses have picked up (Exhibit 2).

Exhibit 2

Conditions Appear Weaker in U.S. Amortizing BB Tranches

In Europe, while direct exposure to software risk has been lower, reduced diversification and higher single-name concentrations have weighed on MVOC cushions. Pressure is evident even in reinvesting deals, with European mezzanine, particularly B tranches, showing more pronounced deterioration. Though European BB tranches have avoided the scale of coverage breaches seen in the U.S., underlying credit quality continues to weaken (with roughly 7% of European B tranches now below full coverage (Exhibit 3)).

Exhibit 3

Dispersion Across Reinvestment Periods in EUR Single B Rated Tranche MVOC

Recent rating agency downgrades reinforce that this deterioration is no longer theoretical. MVOC compression is increasingly translating into realized shortfalls, underscoring its relevance as an early indicator of principal risk.

Underlying Loan Price Dispersion

Beneath modest index-level price moves, dispersion across sectors and issuers remains significant, reflecting a broader “K-shaped” recovery across corporate credit. While the broader loan market is down roughly two points year to date, software and AI-exposed credits have materially underperformed, with average declines closer to eight points. Approximately 42% of software names now trade below $90, while roughly 40% of the broader market remains above par.² This divergence is a key driver of widening differences in CLO portfolio performance (Exhibit 4).

Exhibit 4

The Underperformance of Software-Exposed and AI-Disrupted Loans

Default Risk

While realized CLO tranche default rates remain historically low, recent rating trends and credit indicators point to a growing accumulation of stress in mezzanine risk. Downgrade activity accelerated in 2025, with more than 100 S&P downgrades across U.S. junior tranches, including 32 originally rated BBB. This trend has continued into 2026 as deals move further beyond reinvestment periods and credit deterioration becomes more visible.

Importantly, this shift is beginning to translate into realized outcomes, including the first post-crisis European default in a single-B tranche—marking a notable inflection point.

Historically, defaults have been contained at roughly 2% for BBs and 8% for Bs for U.S. 2012–2018 loan vintages, but outcomes are highly vintage-specific. Newer vintages are entering a more challenging credit environment with weaker collateral, thinner cushions, and longer durations, suggesting future losses could be more persistent and more broadly distributed. As a result, the link between downgrades (~9% in 2025 and ~2% year to date in 2026) and impairment is becoming more direct.

Conclusion

As dispersion among CLO mezzanine tranches continues, manager selection and portfolio construction are no longer secondary considerations, but are being uncovered by the market as primary drivers of outcomes. Differences in sector exposure, trading flexibility, and positioning within stressed credits increasingly determine whether portfolios preserve value or experience meaningful erosion. At the same time, the repricing of underlying credit has already translated into a growing incidence of mezzanine stress, including a rising tally of BB impairments, alongside a continued compression in MVOC cushions. 

The reduced ability of certain CLO tranches to absorb further stress indicates the growing fragility of mezzanine tranches. It also supports our long-held preference for high-quality CLO tranches and demonstrates why selectivity and seniority matter more than ever in today’s market.