- Investment Director
United States, Institutional
Change
The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Key points:
- When investing in collateralized loan obligation (CLO) equity, balancing both short- and long-term views matters. Short-term arbitrage defines the initial deal economics, but performance over the deal life ultimately drives returns.
- This is because day-one metrics are not predictive of realized internal rates of return (IRRs). In fact, historical data show little correlation between initial arbitrage and long-term investment outcomes.1
- In reality, long-term value is built on CLO equity’s structural flexibility. The reinvestment, trading, and refinancing options embedded in CLOs have the potential to provide enduring upside across market cycles.
CLO equity offers a classic example of short- versus long-term thinking. Investor dialogue and market research often emphasize short-term conditions, such as arbitrage spreads or near-term credit sentiment. But, in our view, this underappreciates the compounding impact of long-term optionality in the structure. This is not unlike equities, where Apple’s next quarterly beat dominates the popular press more than the 10-year view on the free cash flow.
In this paper, we explore the impact of both short- and long-term considerations on CLO equity returns.
The role of short-term thinking
When evaluating CLO equity opportunities, market participants often focus on current credit spreads, funding costs, and the arbitrage between asset and liability yields. This emphasis is understandable, as short-term variables are measurable, can be modeled, and provide immediate feedback on performance.
For “fast money” investors, those who seek to extract value from the first few quarterly distributions before trading out of a deal, short-term arbitrage is often the primary decision factor. These investors rely on predictable early cash flows and prefer environments where the arbitrage is high and predictable on day one.
From a structural standpoint, the day-one arbitrage (the difference between the yield on underlying leveraged loans and the cost of CLO liabilities) serves as the investor’s initial hurdle rate. Entering a deal with unattractive arbitrage creates early headwinds to realizing value. Both short-term and long-term investors should avoid deals with weak creation economics.
However, while day-one arbitrage defines the starting point, it does not determine the destination (and should not dominate the investment thesis). For investors with multiyear horizons, short-term thinking should be one input among many.
The case for long-term thinking
The data tells a clear story when assessing CLO equity performance across market cycles. Long-term outcomes depend far more on structural features and reinvestment dynamics than on arbitrage at issuance.
Research, including our own proprietary data, shows little correlation between initial arbitrage levels and realized IRRs.1 In other words, deals launched in tight spread environments have often achieved comparable returns to those issued in wider-spread markets. Arbitrage regularly shifts around what would be considered a fair value, yet through these fluctuations, 90% of CLO equity investments historically have produced positive IRRs,2 regardless of starting conditions.
This resilience reflects the strength of the CLO structure and its ability to adapt across cycles. Once the deal begins reinvesting, day-one metrics quickly lose relevance. CLO vehicles typically have a seven- to eight-year life, so the conditions across that full period matter more than the initial setup. From the first reinvestment date onward, collateral pool characteristics and arb evolve through manager decisions (such as loan selection, trading, and refinancing), all of which reshape ultimate deal performance.
To be clear, we are not advocating ignoring the arbitrage and issuing in any environment. All investors should have discipline and the deal-creation economics do matter, in our view. But where we may differ slightly from conventional thought is we place greater emphasis on the impact that changing factors and optionality over the life of the structure can have on ultimate returns.
Why CLO equity endures: Embedded optionality
CLO equity holders effectively own a set of three long-dated options that create upside potential over the life of the vehicle.
- The reinvestment option
CLOs typically feature a five-year reinvestment period during which principal proceeds and prepayments can be redeployed into new loans. With annual loan repayment rates of 15% – 25%, managers continuously reshape portfolios.
Notably, in 100% of rolling five-year periods since 2000, loans have traded above the 75th percentile at some point, meaning managers have consistently been able to reinvest at higher spreads at some point in the typical five-year reinvestment period. This recurring opportunity enhances long-term returns and diminishes the impact of initial arbitrage through time.
- The convexity option
CLO equity also benefits from the ability to purchase loans at discounted prices during market dislocations. As loans recover in value, these gains accrue directly to equity, typically around 10x levered.3 This convexity effect compounds total returns and introduces a countercyclical advantage: Volatility can be a source of value creation over a deal’s life.
- The refinancing and reset option
Over time, managers can refinance or reset CLO liabilities to lower funding costs or extend reinvestment periods. These structural levers enable equity holders to capture additional spread and extend value realization across multiple market cycles.
Together, these three options form the backbone of long-term performance. While short-term arbitrage defines the starting yield, it is the ongoing exercise of these options that can sustain and amplify equity returns over the full life of a CLO.
Integrating short- and long-term perspectives
We believe investors are best served by approaching the asset class with a balanced investment framework that acknowledges the potential impact of both horizons. Importantly, the emphasis on short-term arb versus long-term optionality depends on an investor’s time horizon and style preference.
- For short-term strategies: Investors focused on trading or recycling capital within six to 18 months should weigh current arbitrage more heavily, in our view. Entry economics and near-term distribution potential will more directly drive returns over this period and exit timing will depend on secondary market liquidity.
- For long-term strategies: We believe investors holding through the life of the CLO should treat day-one arbitrage as a threshold test that is important but secondary. In our view, greater emphasis should be placed on the manager’s credit selection, reinvestment discipline, and ability to exploit optionality.
The key is alignment between investment horizon and decision weighting. Long-term investors who anchor on short-term spreads risk missing opportunities in seemingly tight markets that later prove highly profitable. Conversely, short-term traders who ignore entry economics risk early underperformance.
CLO equity: Should we think fast or slow?
The debate between short- and long-term thinking in CLO equity is not a binary choice. We believe it is complementary, and investors must “think fast and slow,” recognizing that both time horizons inform intelligent capital deployment.
Critically, however, we believe the data supports greater emphasis on the long term. CLO equity’s durability across decades of market cycles reflects its embedded flexibility and compounding potential. While day-one arbitrage sets the opening conditions and helps investors avoid unattractive deals, the real alpha can emerge from patient stewardship through disciplined reinvestment, dynamic trading, and prudent refinancing over time.
1Source: BofA Global Research, exhibiting 1,383 managers. Based on average quarterly arbitrage and average quarterly IRRs between 31 January 2012 and 31 December 2023. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. | 2Sources: BofA Global Research, PriceServe, Intex; from 1 January 2003 through 30 June 2025. BofA data looks at 1,290 CLO equity deals where returns have been realized. No outstanding deals are captured in the data. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. | 3Sources: Intex, LPC Collateral, Wells Fargo Securities. Based on data showing manager style and characteristics from a sample of 1,635 post-crisis, pre-EoRP, US BSL CLOs – deals issued after April 2025 are not included. Within this universe, approximately 8.6% of each CLO consists of equity and 91.4% of the CLO consists of debt, which creates a leverage ratio of 10.6x. Future CLO deals may have different leverage due to market conditions or other factors. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS AND AN INVESTMENT CAN LOSE VALUE.
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