CLO market experts join SCI's webinar to discuss how managers and investors are navigating a divided leveraged loan landscape

Bifurcation in the leveraged loan market has become a defining theme for CLO participants over the past two years, presenting managers with growing challenges as they navigate an increasingly K-shaped credit universe across both the US and Europe.

In a webinar hosted by SCI on February 3, experts from KBRA, Pearl Diver Capital, and Palmer Square Capital Management shared insights into ongoing loan market bifurcation and the resulting dispersion across CLO portfolios as the market moves through 2026.

Gabriele Gramazio, senior director at KBRA, described the divide in today’s loan market is driven more by issuer- and price-level differentiation than sector-wide stress.

Rather than systemic weakness concentrated in specific industries, Gramazio noted that divergence is emerging within sectors, separating stronger credits from weaker ones. This is particularly evident in pricing dynamics and access to refinancing, and is partly influenced by CLO market technicals.

“As CLOs become a more important force in the leveraged loan market, and portfolio managers are restricted to purchasing certain assets when constructing portfolios, this could somehow distort pricing in the underlying loan market to some extent,” he said.

Sector pressure points emerge

When asked where bifurcation is most visible, Jon Brager, partner and portfolio manager at Palmer Square Capital Management, pointed to the European chemicals sector as a key source of dispersion within CLO portfolios.

He highlighted recent stress among large issuers such as Ineos Group and Ineos Quattro, which together represent around 2% of the European Leveraged Loan Index (ELLI) but have traded down by 20 to 30 points.

“Add this to a dozen or so other chemicals names in stress or distress, and the sector becomes a critical one for managers to navigate,” he said.

Brager also identified software as an increasingly important sector to watch in both Europe and the US. He noted that Palmer Square has shifted its positioning, moving from an overweight stance prior to 2025 to an underweight allocation today.

“Regardless of whether you think a particular software company has strong competitive advantages, future cash flows are more uncertain now, and enterprise values should reflect that,” he continued.

“If you’re lending based on a low loan-to-value narrative, that assumption may be less reliable today. Some software companies with leverage of seven to eight times may not have the equity cushion investors previously believed.”

Transparency highlights risks and technical distortions

Pak Sum Chan, partner at Pearl Diver Capital, emphasised that bifurcation is clearly visible to CLO investors due to the asset class’s transparency.

“BSL CLOs are a very transparent asset class. Investors have clear visibility into what managers are buying and selling through detailed trade data,” Chan said. “This allows investors to see how portfolios are evolving, particularly around resets, and how managers respond to downgrades or trade out of weaker credits.”

However, Chan warns that technical factors remain a key risk, particularly uncertainty around how much capital remains on the sidelines and how long it will continue supporting the market.

“The key point for us is that underlying credit risk hasn’t decreased, but spreads have tightened significantly,” he said. “Too much capital chasing too few opportunities has pushed spreads back toward post-crisis lows.”

This dynamic makes it difficult to determine whether tighter spreads reflect genuine credit strength or simply strong technical demand.

Chan added that existing bifurcation could widen further in a downturn, noting that weaker credits historically suffer disproportionately during periods of credit decompression.

“Stepping into weaker B3 and triple-C risk simply because valuations appear attractive is dangerous,” he said. “In our view, that’s picking up pennies in front of a steamroller.”

Manager decisions drive CLO dispersion

Turning to dispersion across CLO portfolios, Brager referenced recent data from Barclays showing significant variation among managers. Across firms with five or more outstanding deals spanning multiple vintages, triple-C buckets ranged from 1% to 9%, WARFs from 2,700 to 3,100, and MVOCs from 102% to 110%.

The panellists agreed that much of this dispersion reflects differences in manager decision-making and investment philosophy.

Brager said divergent risk appetites play a major role. More conservative managers often retain larger portions of their equity tranches, aligning incentives with long-term performance. By contrast, managers who rely more heavily on third-party equity investors may need to generate higher spreads by constructing riskier portfolios.

Credit selection is another critical factor, particularly for loans trading in the 80 to 90 price range.

“That’s one of the hardest challenges for CLO managers,” Brager said. “Historically, six to eight out of ten loans in that range will eventually recover to par. The challenge is identifying the few that won’t. Selling every loan that dips into the 80s would destroy too much par and jeopardize deal performance.”

Chan agreed, noting that the market has not yet experienced sustained volatility sufficient to fully differentiate stronger managers from weaker ones.

He cautioned that some managers may attribute success to skill when it may partly reflect favourable timing or limited exposure to troubled credits.

“A manager with zero exposure to a stressed name isn’t necessarily more skilful than one who recognised the risk early and exited at higher prices,” Chan said. “Consistently managing risk across multiple credits is what truly demonstrates skill.”

CLO growth may exacerbate bifurcation

Looking ahead, Gramazio warned that continued CLO market growth amid limited loan supply could further increase the asset class’s influence on pricing dynamics.

“The leveraged loan market isn’t growing significantly, yet the CLO market continues to expand,” he said. “As CLOs account for a larger share of loan ownership, their influence on pricing will increase, potentially exacerbating bifurcation.”

He also pointed out that triple-A spreads remained relatively stable around 130 basis points last year but are now beginning to tighten in line with underlying loan spreads. This could support continued reset activity following elevated volumes in 2025.

Additionally, Brager added that resets may provide managers with an opportunity to reposition portfolios and address credit divergence.

“Resets aren’t just about managing triple-C buckets,” Brager said. “We view them as an opportunity to rebuild portfolios as if they were new issues - adjusting exposure to weaker credits, repositioning risk, and optimising overall portfolio quality.”

“That flexibility makes resets an important tool for managing both loan market and CLO tranche dispersion,” Brager concluded.

If you would like access to the full webinar recording, click here.

Solomon Klappholz

Ramla Soni