The market overestimates the immediate impact of AI on software companies, creating an opportunity in their debt. While the long-term threat is real (5-15 years out), most companies will have at least one chance to refinance their loans before facing an existential crisis from AI disruption.
Counterintuitively, the primary risk for CLO equity is not loan defaults but a bull market causing credit spread compression. When loan spreads tighten faster than CLO liability costs, the net interest margin for equity holders gets squeezed, as seen in the negative returns of 2023.
Instead of competing, the private credit market often serves as a safety valve for companies struggling in the syndicated loan market. These borrowers can refinance into private credit, accepting higher interest rates in exchange for a more accommodating lender group and crucial time to turn their business around.
The reported ~1% corporate loan default rate is misleadingly low. Many restructurings happen via out-of-court "liability management exercises" where a 51% majority of lenders can force new terms on the minority. This constitutes a real economic loss for some lenders without being recorded as a formal default.
Business Development Company (BDC) debt has an almost perfect repayment history due to the 1940 Act's Asset Coverage Ratio. This rule forces BDCs to halt dividends and redemptions if asset values fall too low, creating a powerful structural protection for creditors that exists independently of the underlying portfolio's quality.
CLO equity can deliver its best performance during periods of high defaults. This is because market price volatility for loans typically exceeds actual credit losses. CLO managers can then use cash flows to purchase performing loans at deep discounts, which ultimately pay off at par, boosting returns.
SRTs offer exposure to loan portfolios like CLOs but without the Net Asset Value (NAV) risk. In an SRT, performing loans are not sold at market value at the end of the deal; the synthetic contract is simply unwound at par. This removes the mark-to-market price volatility that impacts CLO equity.