Bank of America: Structured finance spreads tighten as highly rated and junior CLO assets diverge

Why did spreads suddenly tighten?

In October, investors withdrew from the structured finance primary market, issuance spreads on new deals widened and some deals were postponed; by the end of last week, spreads had tightened across most secondary-market sectors and credit curves had flattened.
The size of secondary-market bid lists plunged approximately 75% from the previous period. BofA believes reduced supply may have partly supported the tightening in spreads; primary-market deals remain difficult to place.
BofA believes floating-rate products are attractive in an environment of rising and volatile interest rates, and diversified loan pools also offer diversification; however, higher rates also dampen risk appetite and increase the interest burden on unhedged borrowers.

As of the report, US and European AAA-rated CLO bonds had returned 3.9% and 2.8% respectively since the start of 2026, while investment-grade corporate bonds in both regions had returned approximately negative 1%. BofA expects CLOs to continue outperforming, partly because floating-rate assets are less affected by fluctuations in fixed rates.
Demand from investors provides support: US CLO ETFs have received net inflows of 20 billion dollars this year, while Europe has received 2.2 billion euros. EU Solvency II reforms will take effect in late January 2027; BofA expects the reduced capital requirements to benefit AAA-rated bonds primarily, with less benefit for AA-rated bonds.
Competition is also intensifying. BofA expects AI-related bond issuance to reach 1 trillion dollars in the following year, potentially diverting demand; demand for CLO AAA bonds will face pressure if their spreads do not provide additional compensation.

Among European single-B CLO bonds, approximately 26% have market value coverage below 100%, compared with just 5% at the start of the year. This measure assesses the extent to which assets valued at current market prices cover the bonds; insufficient coverage means price declines have eroded protection, although some loans may ultimately still be repaid at par.
For European CLOs in their reinvestment periods, median equity cash distributions fell to 2.4% in October, below 2.6% in the previous quarter and a record low for the European CLO 2.0 market. Earlier widespread loan repricing compressed asset spreads; recent weakness in the loan market has brought repricing to a near standstill, easing the pressure somewhat.
Falling loan prices have also depressed net asset values: median European CLO equity NAV fell to 15%, down 26 percentage points from the start of the year, and nearly a quarter of deals have negative equity NAV. BofA believes equity holders may need to inject substantial capital for some deals to reset.
BofA favors higher-quality European single-B bonds while avoiding portfolios with low market value coverage or high proportions of low-priced or CCC-rated loans.

UK housing demand has weakened: the rate on new two-year mortgages with a loan-to-value ratio of 75% rose from 3.9% in January 2026 to 5.1% in September; housing transactions fell 27% in the first half, after rising 14% in 2025.
BofA believes low supply and a first-time buyer support program starting in 2027 help provide a floor, but higher mortgage rates and weaker household incomes have a greater impact. It expects nationwide home prices to rise only by a low single-digit percentage in 2027.
Repayment performance has improved for European commercial mortgage-backed securities: of the 12 loans maturing in 2026, 9 were repaid, 2 received agreed extensions and 1 defaulted; maturities total less than 1 billion euros in each of 2027 and 2028, but rise to 8.1 billion euros in 2030.