CLO Liquidity Risk
Liquidity risk—the risk that investors cannot quickly sell CLO positions without significant price concessions—varies dramatically across the capital structure. AAA tranches trade actively with 10-30 bps bid-ask spreads, while CLO equity can be nearly illiquid with 5-15 point spreads. Understanding liquidity profiles is critical for portfolio construction, particularly for institutional investors with mark-to-market accounting or potential redemption obligations.
Liquidity by Tranche
Overall Market Liquidity Profile
| Tranche | Bid-Ask Spread (bps) | Typical Trade Size | Time to Execute | Liquidity Rating |
|---|---|---|---|---|
| AAA | 10-30 bps | $10-50M | Same day | Very High |
| AA | 30-60 bps | $5-20M | 1-2 days | High |
| A | 50-100 bps | $3-10M | 2-5 days | Moderate-High |
| BBB | 75-150 bps | $2-8M | 3-7 days | Moderate |
| BB | 100-250 bps | $1-5M | 1-3 weeks | Low-Moderate |
| B | 150-350 bps | $500K-2M | 2-4 weeks | Low |
| Equity | 300-1500 bps (3-15 points) | $2-10M (full position) | 1-6 months | Very Low (Illiquid) |
AAA Tranche Liquidity: The Deepest Market
Why AAA Is Most Liquid
- Largest tranche size: 60-65% of every CLO = $300-450M in typical $500-700M deal
- Fungible: One Tier 1 manager AAA trades similarly to another Tier 1 AAA (credit differentiation minimal)
- Broad buyer base: Banks, insurance, asset managers, pension funds, foreign investors all buy AAA
- Dealer support: 10-15 major dealers make markets (JP Morgan, BofA, Citi, Barclays, etc.)
- Rating consistency: AAA means AAA; minimal credit analysis required
AAA Trading Dynamics
Normal market conditions (2024):
- Bid-ask spread: 10-20 bps for Tier 1 managers, 20-30 bps for Tier 2/3
- Trade execution: $10-25M blocks trade same day
- Price discovery: Transparent; Bloomberg/Trace pricing updated intraday
- Secondary market volume: $2-5B weekly trading volume (5-10% of outstanding annually)
Stress conditions (March 2020 COVID crash):
- Bid-ask spread: Widened to 100-300 bps (dealers pulled back liquidity)
- Price impact: Large blocks ($50M+) moved prices 1-3 points
- Forced sellers: Open-end mutual funds and ETFs faced redemptions, selling at distressed prices (88-92 cents)
- Recovery: Liquidity normalized within 6-12 weeks as Fed intervened
Factors Affecting AAA Liquidity
| Factor | Most Liquid | Less Liquid |
|---|---|---|
| Manager Tier | Tier 1 (Blackstone, Oak Hill, PGIM) | Tier 3/4 (unknown managers) |
| Vintage | 2020-2024 (recent vintages) | Pre-2015 (seasoned deals) |
| Deal Size | $500M+ (larger deals) | <$400M (smaller deals) |
| Tranche Size | $300M+ AAA tranche | <$200M AAA tranche |
| Pricing | Current market spreads (SOFR+140) | Off-market pricing (SOFR+110 or +180) |
Mezzanine Tranche Liquidity (AA, A, BBB)
Moderate Liquidity, Higher Spreads
Mezzanine tranches trade less frequently than AAA but remain reasonably liquid for institutional-sized positions:
AA tranches:
- Buyer base: Insurance companies (30-40% of market), asset managers, international investors
- Bid-ask: 30-60 bps (30-40 for Tier 1, 50-60 for Tier 2)
- Typical trade: $5-15M executes in 1-3 days
- Challenge: Smaller tranche sizes ($30-50M) mean fewer natural sellers
A tranches:
- Buyer base: Asset managers, credit opportunity funds, insurance
- Bid-ask: 50-100 bps
- Typical trade: $3-8M takes 3-5 days
- Manager differentiation matters: Tier 1 vs. Tier 3 A tranches can trade 50-100 bps apart
BBB tranches:
- Buyer base: Crossover investors (HY funds, credit opportunity), some insurance
- Bid-ask: 75-150 bps (wider during stress)
- Typical trade: $2-5M takes 5-10 days
- Stress sensitivity: March 2020 saw BBB tranches fall to 65-75 cents (25-35% declines) before recovering
High Yield Tranche Liquidity (BB, B)
Low Liquidity, Wide Spreads
Non-investment grade CLO debt trades infrequently with significant friction:
- Small buyer universe: HY-focused funds, hedge funds, specialized CLO investors
- Manager selection critical: Investors conduct full credit analysis (not just relying on rating)
- Tranche size small: $20-30M BB tranches = 5-10 distinct buyers maximum
- Hold-to-maturity bias: Most investors buy intending to hold 7-10 years
Trading challenges:
- Finding counterparty can take weeks
- Price negotiation required (no transparent market pricing)
- Bid-ask spreads 1-2.5 points (100-250 bps)
- Large positions (> $5M) may require 4-8 week marketing process
CLO Equity Liquidity: Highly Illiquid
Why Equity Is Illiquid
- No fungibility: Every equity position unique (manager quality, vintage, portfolio composition all vary dramatically)
- Tiny buyer universe: 50-100 institutional buyers globally (hedge funds, PE firms, family offices)
- Full due diligence required: Buyers analyze manager track record, portfolio holdings, OC cushions (4-8 week process)
- Hold forever bias: Most equity investors buy with intent to hold to maturity (10-12 years)
- No dealer market: Banks don't make markets in equity (too risky, capital-intensive)
Equity Trading Realities
Typical transaction process:
- Weeks 1-2: Seller approaches 10-15 potential buyers; shares high-level details
- Weeks 3-4: 3-5 interested buyers request full data room (trustee reports, manager calls, portfolio analysis)
- Weeks 5-8: Buyers conduct due diligence; negotiate price
- Weeks 9-12: Documentation, legal review, closing
Bid-ask spreads:
- Best case (Tier 1 manager, strong vintage): 3-5 points (300-500 bps)
- Typical: 5-10 points
- Stressed (Tier 3 manager or weak portfolio): 10-20 points
Example: Seller seeks to exit $10M equity position in 2018 vintage Tier 1 CLO. Fair value estimate: 108-110 cents. Realistic bid: 100-105 cents. Time to execute: 2-4 months. Net liquidity cost: 5-10%.
Secondary Equity Market Size
- Annual secondary volume: $3-5B (vs. $20-30B equity issuance)
- Turnover: 3-5% of outstanding equity trades annually (vs. 15-20% for AAA)
- Motivation for selling: Portfolio rebalancing, fund liquidations, forced sales (not voluntary profit-taking)
Liquidity During Market Stress
Case Study: March 2020 COVID Crash
Liquidity evaporated across all tranches as dealers withdrew and forced sellers dominated:
| Tranche | Normal Bid-Ask | March 2020 Bid-Ask | Price Decline | Recovery Time |
|---|---|---|---|---|
| AAA | 10-20 bps | 100-300 bps | 8-12% | 6-8 weeks |
| AA | 30-60 bps | 200-500 bps | 12-18% | 10-14 weeks |
| A | 50-100 bps | 300-700 bps | 15-22% | 14-20 weeks |
| BBB | 75-150 bps | 500-1500 bps | 25-35% | 20-30 weeks |
| BB | 100-250 bps | No meaningful market | 35-50% | 30-40 weeks |
| Equity | 300-1000 bps | No bids | 50-70% | 40-60 weeks |
What caused illiquidity:
- Dealer retreat: Banks reduced risk appetite; stopped making markets
- Forced sellers: Leveraged funds, open-end mutual funds, ETFs faced redemptions and margin calls
- Buyer strike: Natural buyers (insurance, asset managers) waited for clarity before committing capital
- Price discovery breakdown: No consensus on fair value; buyers and sellers 10-20 points apart
Recovery drivers:
- Fed intervention: Corporate credit facilities (though CLOs ineligible) restored confidence
- Technical demand: Forced selling exhausted; opportunistic buyers emerged
- Fundamentals reasserted: Default rates peaked at 3.4% (not 10-15% feared); CLO structures held
Implications for Investors
Liquidity-Adjusted Return Expectations
Investors should demand illiquidity premiums for less-liquid tranches:
| Tranche | Base Spread | Illiquidity Premium | Fair Value Spread |
|---|---|---|---|
| AAA (liquid) | +120 bps | 0 bps (benchmark) | +120 bps |
| AA (moderate) | +165 bps | +10-15 bps | +175-180 bps |
| BBB (lower liquidity) | +300 bps | +25-50 bps | +325-350 bps |
| BB (illiquid) | +550 bps | +75-125 bps | +625-675 bps |
| Equity (very illiquid) | 12% IRR | +200-400 bps | 14-16% IRR |
Portfolio Construction Considerations
- Match liquidity to liabilities: Open-end funds should overweight AAA (can liquidate quickly); closed-end funds can hold BBB/equity
- Maintain dry powder: Keep 10-20% cash/liquid securities to meet redemptions without forced selling
- Diversify by manager tier: Tier 1 AAA has 2-3× better liquidity than Tier 3 AAA
- Avoid concentration: Single $50M AAA position easier to sell than 10× $5M positions in different deals
- Stress test liquidity: Assume 2-3× normal bid-ask spreads during market dislocation
Key Takeaways
- Liquidity varies dramatically: AAA (10-30 bps bid-ask) vs. equity (3-15 points)
- AAA tranches most liquid: $2-5B weekly volume, same-day execution for $10-25M blocks
- Mezzanine (AA/A/BBB) moderate liquidity: 3-10 day execution, 50-150 bps bid-ask
- CLO equity highly illiquid: 2-4 month sale process, 5-10 point spreads, 3-5% annual turnover
- March 2020 stress: AAA bid-ask widened 10-15×; BBB/equity had no meaningful market
- Illiquidity premiums: Demand +25-50 bps for BBB, +200-400 bps for equity vs. liquid alternatives
- Portfolio construction: Match liquidity to fund structure (open-end needs AAA; closed-end can hold equity)