Collateralized Loan Obligations Research Articles

Unveiling Mispricing Risks: Nonlarge Homogeneous Portfolio Factor Copula Models for Enhanced Valuation of Subordinated Loan Securitization

AbstractThis paper presents an innovative factor copula model for collateralized loan obligation (CLO) tranche valuation, incorporating non‐Gaussian distributions and dynamic correlations without relying on the large homogeneous portfolio (LHP) assumption. Through numerical analyses and comparisons with LHP models, I find that non‐LHP models produce higher tranche spreads, especially for lower‐rated tranches. Sensitivity analysis reveals varying sensitivities to changes in the number of collaterals, risk‐free rate, average collateral ratings, recovery rates, and time to maturity. The non‐LHP one‐factor copula models, including stochastic correlation and random factor loading models, outperform LHP models in root mean squared errors when calibrated to market data. The results underscore the importance of considering model limitations in CLO tranche pricing and highlight potential mispricing of spread risk in higher‐rated tranches using LHP models. The proposed models contribute to a more comprehensive understanding of CLO tranche pricing by accounting for various factors and assumptions influencing fair premiums.

A Benchmark for Collateralized Loan Obligations

We build a benchmark for AAA-rated tranches of collateralized loan obligations (CLOs) using business development companies (BDCs), which hold a diversified portfolio of loans as CLOs do. BDCs are publicly listed, and their share price, equity volatility, and borrowing cost can be easily obtained. Applying a structural model to BDCs, we extract market-implied correlation in their loan portfolio, compare spreads on CLO tranches and BDC-implied benchmark, and find that observed large credit spreads on CLO senior tranches after the financial crisis are a fair reflection of the systematic risk of correlated loan defaults. This paper was accepted by Lukas Schmid, finance. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2022.00097 .

Dual holdings and shareholder–creditor agency conflicts: Evidence from the syndicated loan market

AbstractWe examine implications from the expansion of private equity (PE) firms into the collateralized loan obligation (CLO) (i.e., leveraged lending) business. Due to similarities in the investment universes of CLO managers and PE firms, asset managers running both of them frequently hold debt and equity claims of the same company. Our results indicate lower credit costs for these companies through the mitigation of shareholder–creditor agency conflicts. The lower funding costs imply increased equity returns for the sponsoring PE firms. In addition, our findings suggest that PE‐affiliated CLO managers benefit from informed trading in the secondary leveraged loan market.

The dynamic connectedness between collateralized loan obligations and major asset classes: a TVP-VAR approach and portfolio hedging strategies for investors

Motivated by the increasing demand for alternative assets that can contribute to reducing portfolio risk, this paper examines the volatility spillovers between collateralized loan obligations (CLOs) and various in-demand investment instruments, including equities, bonds, crude oil, commodities, gold, bitcoin, shipping and real estate. The applied methodology comprehends the time-varying parameter vector autoregressive (TVP-VAR) modification of the classical spillover approach, for the period from January 1, 2012, to August 31, 2023. The empirical findings show moderate levels of dynamic connectedness; albeit several external shocks strengthened the interconnection among the assets. Moreover, we compare the ability of CLOs for hedging, during the overall sample period and multiple subperiods, by estimating hedge ratios and optimal portfolio weights, in order to inform investors about feasible portfolio adjustments. Our results indicate that CLOs constitute an effective hedging tool, irrespective of the period covered, as the short position in their volatility provides high hedging effectiveness for investors holding long positions in the volatility of all the remaining assets.

Private Equity in Distress and the Incentives of Collateralised Loan Obligations

Abstract This article explores the problem that both modern private equity (PE) firms, and collateralised loan obligation (CLO) lenders to PE portfolio companies, have incentives to avoid a formal restructuring of PE portfolio companies in financial distress. The author is concerned that this may lead to negative social costs for suppliers, employees, customers and even government agencies. She explores how and why the problem arises, and the ways in which corporate and corporate insolvency law might be able to respond to it. Some suggestions are made, but it is accepted that any solution involves a sensitive balance that needs to be approached with considerable care.

A Survey of Private Debt Funds

Abstract Despite its large and increasing size in the United States and Europe, the private debt (PD) market, compared to the bank and syndicated loan markets, has been researched little. In this paper, we survey U.S. and European investors with private debt assets under management (AuM) of over $390 billion. These investors are primarily direct lending funds. We ask the general partners (GPs) how they source, select, and evaluate deals; how they think of private debt relative to bank and syndicated loan financing; how they monitor their investments; how they interact with private equity (PE) sponsors; and how they view the future of the market. Respondents provide primarily cash-flow-based loans and believe that they finance companies and leverage levels that banks would not fund. Direct lending funds target unlevered returns that appear high relative to their risk. They use leverage in their funds, but appreciably less than banks and collateralized loan obligation funds (CLOs). They use and negotiate for both financial and negative covenants to monitor their investments. The presence of PE sponsors helps them lend more and craft more effective covenants. U.S. and European funds are similar along many dimensions, but European funds rely less on PE sponsors and compete more with banks. Overall, the private debt market is both different from and shares characteristics with bank loan and syndicated loan markets. (JEL G23, G30, G32)

Adverse Selection Dynamics in Privately Produced Safe Debt Markets

Privately produced safe debt is designed so that there is no adverse selection in trade. But in some macro states—here, the onset of the pandemic—it becomes profitable for some agents to produce private information, and then agents face adverse selection when they trade the debt (i.e., it becomes information sensitive). We empirically study these adverse selection dynamics in a very important asset class, collateralized loan obligations (CLOs), which finance loans to below-investment-grade firms. We decompose the bid-ask spreads on the AAA bonds of CLOs into a component reflecting dealer bank balance sheet costs and the adverse selection component. (JEL D22, D82, E44, G12, G14, G32)

Unlocking the Resilience of Collateralized Loan Obligations: Exploring Historical Global Performance, Regulatory Scrutiny, and the EU Market’s Innovations

This article provides an overview of collateralized loan obligations (CLOs) as securitizations backed by diverse portfolios of senior secured leveraged loans, their historical performance and default rates, and how they differ from other securitization vehicles. It explains the resilience of the asset class, due in part, to covenants that limit risk exposure and offer early identification of stress. This article also discusses the deterioration of covenant quality in leveraged loans and the benefits and drawbacks of covenant-lite loans. The authors refute concerns that CLOs will be the next source of a financial crisis and explain the regulatory and investor scrutiny they are subject to. The European CLO market is well regulated, transparent, and has improved liquidity, with increasing interest in investment-grade tranches. Issuers have adapted and innovated in response to crises, leading to new structural modifications and ESG adoption. The market is expected to remain robust due to its ability to adapt and the improved investor base.

Underwriter reputation and the pricing of securities: Evidence from asset-backed securities

This paper investigates whether and how the underwriter reputation can affect the pricing of securities. Using data on collateralized loan obligations (CLO), asset-backed securities (ABS), and asset-backed medium-term notes (ABN) from 2014 to 2019 in China bond market, we find that the underwriter's reputation has a significantly negative impact on the issuance spread. This effect is more pronounced in the CLO and ABS markets, while that in the ABN market is not significant. Furthermore, we find that the originators play a critical role in determining the issuance spread of securities, as state-owned and listed originator receive a lower initial yield spread. In addition, the number of tranches and the proportion of subordination in a deal also have a stronger effect on the relation between which the underwriters' reputation and securities prices. These results suggest that underwriters play a role in reducing information asymmetry between originators and investors, which is partly corrected via underwriter reputation.

CLO Performance

ABSTRACTWe study the performance of collateralized loan obligations (CLOs) to understand the market imperfections giving rise to these vehicles and their corresponding economic costs. CLO equity tranches earn positive abnormal returns from the risk‐adjusted price differential between leveraged loans and CLO debt tranches. Debt tranches offer higher returns than similarly rated corporate bonds, making them attractive to banks and insurers that face risk‐based capital requirements. Temporal variation in equity performance highlights the resilience of CLOs to market volatility due to their closed‐end structure, long‐term funding, and embedded options to reinvest principal proceeds.

Financial Covenants and Fire Sales in Closed-End Funds

Closed-end funds are thought to have negligible fire sale risk as they have stable funding. However, I show that embedded covenants can generate price pressure in collateralized loan obligation (CLO) funds, even though such funds are closed end. Loans held by constrained CLOs report significantly lower cumulative returns than loans held by unconstrained CLOs. This can be explained by contractual arbitrage, a practice by which CLOs exploit loopholes in the design of covenants to mechanically loosen their covenants and avoid covenant breaches. Covenant breaches are associated with significant pecuniary and nonpecuniary costs, affecting CLO compensation, reputation, and career prospects. I show that when covenants breaches are imminent, managers fire sell distressed loans. Hence, I demonstrate a channel by which closed-end funds can also create fire sale risk, akin to their open-end counterparts. This paper was accepted by Lukas Schmid, finance. Funding: This research was funded by the John and Serena Liew Fellowship Fund at the Fama-Miller Center for Research in Finance at the University of Chicago Booth School of Business, the University of Chicago PhD Program Office, the Stigler Center for the Study of the Economy and State, and the University of Chicago Library. Supplemental Material: The data files and online appendices are available at https://doi.org/10.1287/mnsc.2023.4708 .

A Benchmark for Collateralized Loan Obligations

We build a benchmark for AAA-rated tranches of Collateralized Loan Obligations (CLOs) using Business Development Companies (BDCs), which hold a diversified portfolio of loans as CLOs do. However, BDCs are publicly listed, and their share price, equity volatility and borrowing cost are observable. Furthermore, BDCs' debt is not rated as AAA. Applying a structural model to BDCs, we extract market-implied correlation in their loan portfolio, compare spreads on CLO tranches and BDC-implied benchmark, and find that observed large credit spreads on CLO senior tranches after the financial crisis are a fair reflection of the systematic risk of correlated loan defaults.

The Externalities of Fire Sales: Evidence from Collateralized Loan Obligations

The Externalities of Fire Sales: Evidence from Collateralized Loan Obligations

A Bottom-up, Reduced Form Credit Risk Model Approach for the Determination of Collateralized Loan Obligation Capital

A Bottom-up, Reduced Form Credit Risk Model Approach for the Determination of Collateralized Loan Obligation Capital

MDB Loans: A New Asset Class for CLOs

Use of structured financings for balance sheet management by multilateral development banks (MDBs) is still in its infancy. Three path-breaking deals by the African Development Bank (AfDB) and International Finance Corporation (IFC) are leading the way, however. The two AfDB deals are both synthetic, with the loans remaining on the balance sheet despite substantial risk transfers. The IFC transaction allows co-funding of private sector loans with other lenders. New insights and opportunities will certainly emerge with rising experience in MDB loan deals. A few imperatives for a robust MDB collateralized loan obligation (CLO) market are already evident: (i) public disclosure of the relevant parts of proprietary historical MDB loan performance data; (ii) more-transparent rating agency criteria for MDB securitizations, and (iii) greater management, investor, banker, and MDB expertise in this asset class.

CLO Conference Notes 2022

The <b>11th Annual Investors’ Conference on CLOs and Leveraged Loans</b> attracted more than 800 market participants and was held on May 23–24, 2022, at the Marriott Marquis hotel in New York City. Key themes at the conference included: 1) the ability of collateralized loan obligation (CLO) managers to deal with evolving conditions, 2) headwinds from inflation, rising interest rates, and the prospect of recession, and 3) the incorporation of environmental, social, and governance (ESG) considerations into CLOs. On the legal/regulatory front, the development that received attention in multiple sessions was the SEC’s proposed rule for private funds. The panels generally conveyed a cautiously optimistic outlook for the CLO sector, but they expect that issuance for 2022 will be below last year’s levels. <b>Sessions Covered</b> <b><i>Monday, May 23 Sessions</i></b> KEYNOTE: Economic Outlook for Financial Markets Mark, Set…CLO: Market Recap and Outlook ESG CLOs: Moving from “Sustainable” to “Conscious” Middle Market CLOs and the Role of Private Credit: Where Are We Headed? CLO Manager Roundtable: Fundamentals and Technicals <b><i>Tuesday, May 24 Sessions</i></b> Credit Fundamentals: The Leveraged Loan Market Outlook Securing Yield: Investor Strategies and Opportunities across the Capital Stack The Evolving Manager Landscape: Evaluating Manager Tiers and Performance Out of the Mist: Emerging Middle Market Trends “The Price is Right!”: Secondary Market Trading CRE CLOs: Expanding Momentum More than Plain Vanilla: CLO Structural Evolution “What’s up Docs?”: CLO Documentation Trends The Innovation Game: Technology and the Future for CLOs

Collateralized Loan Obligations: A Primer

In recent years, collateralized loan obligations, or CLOs, have become the largest nonbank lender in the U.S. This added source of financing, which lies outside the purview of banking regulation, has given rise to the concept of a “shadow banking system.” And the lack of transparency and regulatory oversight of CLOs and shadow banking have led to concern that this growing market might contribute to a financial crisis similar to the GFC of 2007‐2008, which was triggered by the securitization of subprime mortgages.The authors provide a first look at CLOs and their distinctive features as a securitization vehicle that allowed them not only to weather the 2007‐2008 financial crisis but to thrive in the post‐GFC world. Though the collateral performance of CLOs suffered during GFC, their recovery was faster and stronger than that of mortgage‐backed CDOs. Furthermore, the return performance of CLO tranches has in general also been superior to the returns from the comparable leveraged loans upon which CLOs are based—though there are difficulties in measuring returns for CLO tranches since transaction prices are not public information, especially in the case of the equity tranche.After describing their remarkable growth, the authors focus on two fundamental risks posed by CLOs. The first risk relates to the reliability of credit ratings—though it's important to note that the extensive due diligence behind leverage loans versus mortgage loans effectively reduces CLO investors' reliance on the rating agencies. The second risk relates to the systematic risk borne by the CLO investors, which is lower than that of MBS if only by virtue of the fact that CLOs are based on shorter‐term floating rate instruments than 30‐year mortgages. More important, what happens in most MBS, CLO managers can actively manage their loan portfolios in the secondary markets, and effective and active management of collateral works to limit both default risk and the possible effects of systemic shocks.

Middle Market CLO Conference Notes 2022

The <b>1st Annual Middle Market CLOs and Direct Lending Conference</b> attracted more than 700 registrants and was held on June 15, 2022, at Chelsea Piers in New York. Panelists generally expressed cautiously optimistic views for the sector. Key themes at the conference included uncertainty about inflation, the potential for a recession, the rapid growth in middle market (MM) lending, the increasing size of loans originated through private-credit/direct-lending channels, and the strong performance of MM collateralized loan obligations (CLOs) (and their underlying loans) during the COVID-19 pandemic. In addition, several sessions discussed new regulatory initiatives and the growing importance of environmental, social, and governance (ESG) considerations in MM CLOs. <b>Sessions Covered</b> Middle Market Finance Primer Co-Hosts’ Welcoming Remarks Middle Market Finance Strategies and Trends The Direct-Lending Landscape: Opportunities and Threats on the Horizon Key Regulatory Developments for CLOs and Private Credit Health Check: Taking the Temperature of the Middle Market Sector Key Considerations for Investing in Middle Market CLOs: Equity and Debt Investor Roundtable Middle Market CLO Manager Roundtable: Poised for Growth Middle Market Private-Credit Investing: Why are LPs Allocating to the Sector? Emerging Middle Market CLO Trends, Strategies, and Structures

Fire-sale risk in the leveraged loan market

Using detailed loan holding data of Collateralized Loan Obligations (CLOs), we document empirical evidence for the fire sale of leveraged loans due to leverage constraints on CLOs. Constrained CLOs are forced to sell loans downgraded to CCC or below, and thus loans widely held by constrained CLOs experience temporary price depreciation. This instability is exacerbated by diversification requirements. As the CLO market grows, each CLO’s effort to diversify its portfolio leads to similarity in loan holdings among CLOs, and thus their leverage constraints simultaneously bind. CLOs’ overlapping loan holdings spread idiosyncratic shocks to large borrowers to the overall leveraged loan market.

CLO (Collateralized Loan Obligation) Market and Corporate Lending

AbstractWe investigate whether access to the collateralized loan obligation (CLO) market as collateral managers or underwriters affects lenders' ability to overcome an idiosyncratic adverse shock in the corporate lending market. In a triple difference‐in‐differences setting, we find that lenders decrease their origination of loans following a negative shock; however, those with CLO access become more likely to arrange deals with securitizable facilities (Term B). Moreover, they choose to arrange deals with smaller size on‐balance‐sheet lending (Term A). The results suggest that securitization is actively used by lenders to switch to off‐balance‐sheet lending and to reduce the risk retained on the balance sheet.