The Risks and Benefits of Collateralized Loan Obligations

ON 5 MAY 2023
BY FRANCESCO NICOLAI

Imagine you are a bank that lends money to companies with low credit ratings. You know that these loans are risky, but you also know that they offer high returns. How do you balance the trade-off between risk and reward? One way is to bundle these loans together and sell them to investors as collateralized loan obligations, or CLOs. CLOs are complex financial instruments that allow banks to transfer the risk of default to investors and free up capital in order to make more loans, while investors can diversify their portfolios and earn higher yields. But what happens when the economy goes south, and the borrowers start to default? How do CLOs affect the stability of the market for leveraged loans? This is the question we will explore in this blog post.

CLOs are a type of securitization that bundles leveraged loans and sells them as securities to investors. Leveraged loans are high-interest loans to low-rated borrowers. The securities issued by CLOs are called tranches, and they have different ranks, ratings, and rates. The highest-ranked tranche has the lowest risk and the lowest return, while the lowest-ranked tranche has the highest risk and the highest return. The equity tranche is not a security, but a claim on the remaining cash flows of the CLO after paying the other tranches. The equity tranche has the highest potential return, but also the first loss if defaults occur.

CLOs may seem like a novel and complicated financial product, but they actually have a long and varied history in the credit market. They have existed since the late 1980s, but they have changed over time due to market conditions and regulations. The latest version of CLOs, CLO 3.0, started in 2014 and mainly consists of secured loans with little or no exposure to high yield bonds. CLOs have historically performed well compared to other fixed income strategies, especially in low-yield environments. However, CLOs faced significant challenges in 2020 due to the COVID-19 pandemic, which caused a sharp contraction of the global economy and a surge in corporate defaults. CLOs experienced rating downgrades, breaches of overcollateralization tests [1], and difficulties in reinvesting and refinancing.

Despite the challenges, CLOs demonstrated resilience and recovery potential, as they benefited from government and central bank support, loan forbearance measures, and market stabilization. CLOs also showed low default rates compared to other fixed income strategies, as they mostly invested in senior secured loans with strong covenants and diversification [2]. In addition to their historical performance and resilience, CLOs have also demonstrated their value during the recent period of monetary tightening by the Fed, which raised rates several times in 2022 and 2023 to contain inflation and moderate the economic growth.

CLOs have provided several benefits to the financial system compared to a scenario where loans are predominantly held by banks. First, CLOs have reduced the credit risk exposure of banks and increased their lending capacity. Second, CLOs have offered higher returns to investors than other fixed income strategies, as they benefited from the floating-rate nature of leveraged loans and their senior secured position in the capital structure of borrowers. Third, CLOs have supported the liquidity and efficiency of the leveraged loan market, as they increased the demand for loans and facilitated their distribution among a diverse group of investors. Fourth, CLOs have enhanced the financial stability of the system, as they avoided capital outflows and rollover risk during market downturns and mitigated the impact of interest rate hikes on their performance.

Academic studies [3] have found that CLO equity tranches earned positive abnormal returns from the risk-adjusted price differential between leveraged loans and CLO debt tranches. CLO debt tranches also offered higher returns than similarly rated corporate bonds, making them attractive to banks and insurers that face risk-based capital requirements. What makes CLOs less vulnerable to market volatility are features such as their closed-end structure, long-term funding, and embedded options to reinvest principal proceeds. These allow CLOs to avoid capital outflows and rollover risk during market downturns and to take advantage of market opportunities and improve their performance.

However, CLOs are not immune to risks and challenges that could affect their performance and stability. Academic studies show that CLOs could generate contagion and fire-sale risk in the market for leveraged loans due to their leverage and diversification constraints. Researchers have shown[4] that CLOs propagate adverse shocks from troubled loans to healthy loans by liquidating unrelated securities to pass their over-collateralization tests. These tests are based on the historical value of the loans and ignore market prices and ratings. This behavior distorts the secondary market for leveraged loans and affects the borrowing costs of companies in the primary market.

Other studies [5] show that constrained CLOs are forced to sell loans downgraded to CCC or below, which depresses their prices. They also show that this risk is exacerbated by diversification requirements, which induce similarity in loan holdings among CLOs. This mechanism amplifies and spreads idiosyncratic shocks to large borrowers. These studies suggest that CLOs’ leverage and diversification constraints could pose significant risks to the leveraged loan market, especially during periods of market stress and credit deterioration. They also imply that regulators and investors should monitor CLOs’ portfolio composition and performance more closely and take into account the potential spillover effects of CLOs’ trading behavior.

In this post, we have discussed how CLOs performed during Covid and the Fed hikes, and why they are special and risky. Unlike CDOs[6], which were based on mortgages and caused the 2008 financial crisis, CLOs have shown remarkable resilience during the pandemic and the subsequent monetary tightening. This is because CLOs are less complex, more transparent, more diversified, more actively managed, and more senior in the capital structure than CDOs. However, CLOs also pose some challenges and risks for investors, regulators, and the financial system. These include the sensitivity to credit rating changes and defaults, and the systemic implications of CLO interconnections.

Therefore, CLOs require careful analysis and monitoring to ensure their stability and sustainability. Despite these risks, CLOs can also play a positive role in the financial system by providing liquidity and credit to firms that may otherwise struggle to access funding. By transferring risk from banks to a wider range of investors, CLOs can also enhance financial stability and diversification. Thus, CLOs can be seen as a beneficial innovation that supports economic growth and resilience.

Footnotes

[1] Overcollateralization tests are a type of credit enhancement mechanism that protect the CLO debt investors from losses in the underlying loan portfolio. They compare the par value of the loans with the principal value of the CLO debt tranches and ensure that there is sufficient excess collateral to cover potential defaults. If the tests are breached, interest or principal proceeds are diverted from the junior or equity tranches to pay down the senior tranches until the tests are cured.

[2] CLOs have shown lower default rates than the overall loan market, thanks to active management and credit enhancement. According to the Loan Syndications and Trading Association (LSTA), CLOs had a cumulative default rate of 0.38% since 1994, compared to 3.4% for leveraged loans and 4.6% for high-yield bonds.

[3] Cordell, L., Roberts, M.R., and Schwert, M. (2021). CLO Performance. Journal of Finance. Available at SSRN: https://ssrn.com/abstract=3652124

[4] Nicolai, F. (2021). Contagion in the Market for Leveraged Loans. Working paper. Available at: https://francesconicolai.github.io/papers/JMP.pdf

[5] Elkamhi, R. and Nozawa, Y. (2022). Fire-Sale Risk in the Leveraged Loan Market. Journal of Financial Economics. Available at SSRN: https://ssrn.com/abstract=3635086

[6] CDOs (collateralized debt obligations) are financial instruments that pay investors from a pool of revenue-generating sources, such as mortgages, bonds, or credit-default swaps. CDOs are divided into different tranches that represent different risk levels and return rates. CDOs were one of the main causes of the 2008 financial crisis, because many of them were backed by subprime mortgages that defaulted when the housing market collapsed. CDOs were also difficult to price and understand, and were often sold to investors who did not fully grasp their risks and complexities. When the value of the underlying assets dropped, CDOs became worthless and caused huge losses for banks, hedge funds, and other institutions that held them.