Leveraged Loans Research Articles

Analyzing time‐varying tail dependence between leveraged loan and debt markets in the U.S. economy

AbstractThis study analyzes the time‐varying dependence between U.S. leveraged loan and debt markets within a highly linked financial system using a quantile‐based time‐varying connectedness framework to determine the hedging benefits of leveraged loans for financial investors at various quantiles. Based on daily closing price data from November 28, 2008 to October 3, 2023, the evidence demonstrates considerable (moderate) spillovers across the leveraged loan and debt markets for severe (normal) occurrences, with additional results indicating symmetric interaction. In terms of risk spillover, we also affirm the dominance of short‐term fixed‐income instruments over leveraged loans and long‐term bonds. These findings indicate that no hedging or diversification occurred among the investigated markets.

CLO Conference Notes 2023

The <bold>12th Annual Investors’ Conference on CLOs and Leveraged Loans</bold> was held on April 17–18, 2023 at the Marriott Marquis hotel in New York. It was very well attended. Some sessions were standing-room-only. Key themes at the conference included: 1) macroeconomic risks (both inflation and a possible recession), 2) the prospect of rising loan defaults, 3) manager tiering, 4) increasing performance dispersion under stress conditions, and 5) the LIBOR to SOFR transition. The mood was cautiously optimistic, despite looming macroeconomic headwinds. <bold>Sessions Covered</bold> <bold><italic>Monday, April 17 Sessions</italic></bold> IMN & FIIN Welcome Remarks CLO & Leverage Loan Market Outlook Applications of ESG to CLOs Manager Tiering & Consolidation Trends Technology, Innovation, and the Future of CLOs Investor Insights: Opportunities Across the Capital Stack <bold><italic>Tuesday, April 18 Sessions</italic></bold> Fireside with Apollo: Perspectives on Structured Credit Risk CLO Manager Roundtable Documentation Developments Keynote Economic Outlook, with Mark Zandi CLO Debt vs Equity Trustee Evolution & the Role of Collateral Administration

U.S. leveraged loan and debt markets: Implications for optimal portfolio and hedging

This paper offers fresh empirical evidence on the relationship between leverage loans and US debt markets by investigating the distributional predictability and directional predictability between leveraged loans and treasury bonds, fixed income securities and corporate bonds in the U.S economy. We use daily price data from January 2013 to April 2021. First, we analyze the causal relationship between variables by applying non-parametric causality-in-quantiles test and find that quantile causality in variance shows the stronger impact of leverage loan market returns on US debt market returns over the entire quantile range. Second, quantile dependence and directional predictability between leverage loan market and US debt markets are analyzed by applying cross-quantilogram approach and estimated results show the heterogeneous quantile relations from leverage loan market to US debt market. Moreover, the cross-quantile correlation results demonstrate the evidence of negative predictability from leverage loan market to US debt market in low, medium and high quantile range. These evidences are important for US investors and portfolio managers.

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.

Monitoring with Small Stakes: Evidence from Leveraged Loans

Monitoring with Small Stakes: Evidence from Leveraged Loans

Diversification Benefits from Leveraged Loans? Trends in Cross-Asset Correlations

The concept of diversification is well understood by both academics and investment professionals. In forming a mean-variance efficient portfolio, investment managers look for low-correlated assets in order to maximize diversification benefits. This article investigates the potential of European and US leveraged loans to serve as diversifiers in a multi-asset portfolio. By calculating correlations between leveraged loans and other asset classes over the sample period from 2002 to 2020, the authors are not only able to demonstrate increasing correlations in highly volatile markets (i.e., financial crises), but also long-term, crisis-independent positive trends in asset correlations. In particular, leveraged loans and their correlations with stocks and high-yield bonds present significantly positive long-term trends and hence diminishing diversification benefits. The authors state that instead of short-term market volatility, increasing market integration could be the driving force behind this effect. The results also indicate that diversification benefits from leveraged loans are lower in the US than in the European market. TOPICS:Fixed income and structured finance, developed markets, portfolio construction, performance measurement Key Findings ▪ The empirical analysis shows generally stable and low correlations of leveraged loans with most asset classes in European and US markets. Stocks and high-yield bonds are an exception, showing a pattern with rising long-term correlation coefficients. ▪ The correlation of leveraged loans with high-yield bonds is higher than those with other asset classes due to their comparable characteristics. Correlations between those asset classes have risen, especially since the global financial crisis in 2008. ▪ Due to higher market volumes and integration advantages in the US, the correlations of leveraged loans with other assets are higher in the US market, leading to lower diversification benefits compared to Europe.

Leveraged Loans: Is High Leverage Risk Priced in?

The economic downturn caused by the COVID-19 pandemic accentuates extant concerns about the leveraged loan market. Using a novel dataset, we show that leveraged loan spreads have declined for nonbank-facilities since the introduction of the Interagency Guidance on Leveraged Lending (IGLL) and the ensuing “frequently asked questions for implementing the March 2013 guidance”. The decline in leveraged loan spreads is significant for highly leveraged borrowers, especially when involving term loans. We further demonstrate that risk shifting issues associated with the high level of Collateralized Loan Obligations issuance strongly explain the decline of nonbank leveraged loan spreads. In addition, a higher degree of information asymmetry, driven by an increase in covenant-lite loan issuance and weaker investor protection, are strongly associated with the narrowed leverage risk premium.

What Drove Recent Trends in Corporate Bonds and Loans Usage?

&lt;ns2:p&gt;U.S. nonfinancial business debt increased substantially in recent years in both absolute and relative terms and is now near its record high. Figure 1 shows that most of this increase was due to significant growth in investment-grade (IG) corporate bonds and institutional leveraged loans, while high-yield (HY) corporate bonds and C&amp;amp;I loans largely remained steady.&lt;/ns2:p&gt;

Hail the New Private Debt Machine: Private Equity, Leveraged Loans, and Collateralised Loan Obligations

The COVID-19 pandemic and the subsequent worldwide economic slowdown have exposed the fragility of the financial sector, among others. This article argues that the seeds of this fragility, while being exposed by the pandemic, were sown earlier, in the post-2008 years, through the revived synergy of three elements of the financial system: private equity firms ascending the role of ultimate intermediaries in the system of private debt creation; leveraged loans becoming the new asset class that replaced what mortgages represented in the pre-2008 years; and collateralised loans obligations (CLOs) which in some ways replicated the function of CDOs as mechanisms of private debt creation. This article explains this phenomenon, analysing in particular how CLO structures morphed during the last decade and how this new transactional innovation facilitated a return to dangerous levels of leverage. As of 2019, the level of CLO issuance neared $120bn in the US, whereas in the EU they were close to Euro30bn. While the IMF warned at the end of 2019 about the dangers associated with the increasing levels of corporate leverage, confidence in the banking system was reiterated, largely due to the alleged safeness of CLOs, and particularly the capacity of these transactional structures to shift risks away from systemic banks. This article provides some clarity on these apparently contrasting statements, drawing inter alia some parallels with the crisis of 2008.

Will the Leveraged Loan Market Trigger a Financial Pandemic? Understanding Cov-Lite Loans, CLOs and EBITDA Add-Backs

Even before the coronavirus plunged the world's financial markets, analysts and regulators had been describing the $1.2 to 1.5 trillion leveraged loan market as a ticking time bomb likely to play a role in causing the next financial crisis. Many have been denouncing problematic fundamentals in the current leveraged loan market and comparing them to those that caused the 2007 subprime mortgage crisis to spread into a full-blown financial crisis towards the second half of 2008. Two legal innovations in the world of corporate finance are the main anticipated culprits of a future financial meltdown: covenant-lite (or “cov-lite”) loans and Collateralized Loan Obligations (CLOs). Our paper argues that concerns of a systemic breakdown in the financial system as a result of cov-lite loans and CLOs may be overstated. To do this, we first draw from a seminal working paper by researchers at the Federal Reserve of Philadelphia that demonstrate that cov-lite loans are almost universally part of a syndication structure that binds borrowers to compliance with financial covenants. Secondly, the paper succinctly explains CLOs and compares them with similar structured finance and securitization products, such as Collateralized Debt Obligations (CDOs), CDO-squared and CDO-cubed, as well as with derivatives, such as synthetic CDOs and Credit Default Swaps (CDSs), all of which played a role in obscuring financial market fundamentals in the lead-up to the great financial crisis. Third, the paper briefly analyzes the latest stress test results and financial stability reports by regulators in charge of monitoring systemic risk in the banking and wider financial systems. Finally, the paper explores EBITDA add-backs, a product of contract law and accounting that have played an increasing role in large Leveraged Buyout (LBO) deals and could distort a lender's credit monitoring functions, but concludes that they are currently ignored in the ratings analysis of leveraged loans and CLOs.

CLOs, Private Equity, Pensions, and Systemic Risk

There has been much recent discussion of the increasing risk of Collateralized Loan Obligations (CLOs) and their feeder collateral, leveraged loans (LLs). The models ratings agencies use rely on similarly flawed methods in place since the mid-2000s and the nature of the collateral coupled with dramatic recent increases in risk of the underlying loans and conflicts of interest suggest that CLO ratings should be capped at a level far below AAA. Just as in 2008, the market is engaging in a collective grand illusion without adequate scrutiny of the actual risk and meaning of a AAA rating. The risk goes far beyond CLOs and permeates the larger economy. There is frothiness and irrational exuberance permeating an “Iron Triangle” of private equity firms, CLOs, and pension funds. Systemic risk may be realized through significant job losses, rising pension fund deficits, credit losses for funds, insurance companies, and banks, and significant disruption to critical industries. The risk could be on the scale of the global financial crisis (GFC). The main systemic risks include 1) Employment: Private equity-owned companies employ nearly 9 million people; 2) Pension funds: Face potential losses on existing investments and perhaps more importantly may need to revise lower future return assumptions—these factors put millions of pensions at risk; 3) Investment losses: Banks, insurance companies, and funds are exposed to CLO and/or leveraged loans and face significant potential losses; and 4) Critical industry fallout: Many industries controlled by PE companies face widespread disruption should the funding vehicles of CLOs and leveraged loans freeze up. <b>TOPICS:</b>CLOs, CDOs, and other structured credit; financial crises and financial market history <b>Key Findings</b> • This article argues that Collateralized Loan Obligations (CLOs) do not justify AAA ratings and that there is significant systemic risk emanating from the “Iron Triangle” of CLOs, private equity (PE), and pension funds. • The AAA rating should be challenged across two broad fronts: the rating agency approach and the substantial increase in risk in the underlying leveraged loans in recent years. • Systemic risk: The Iron Triangle between CLOs, PE, and Pensions create significant systemic risk potentially on the scale of the Global Financial Crisis (GFC).

Leveraged Loans: Is High Leverage Risk Priced in?

The economic downturn caused by the Covid-19 pandemic accentuates extant concerns about the leveraged loan market. Using a novel dataset, we show that leveraged loan spreads have declined for nonbank-facilities since the introduction of the Interagency Guidance on Leveraged Lending (IGLL) and the ensuing “frequently asked questions for implementing the March 2013 guidance”. The decline in leveraged loan spreads is significant for highly leveraged borrowers, especially when involving term loans. We further demonstrate that risk shifting issues associated with the high level of Collateralized Loan Obligations issuance strongly explain the decline of nonbank leveraged loan spreads. In addition, a higher degree of information asymmetry, driven by an increase in covenant-lite loan issuance and weaker investor protection, are strongly associated with the narrowed leverage risk premium.

Global Forces on the US CLO Market

This article examines the macroeconomic factors that have led the US broadly syndicated loan and collateralized loan obligation (CLO) markets to be the largest in the world then looks at how the markets evolved to the current state and explores some of the current themes facing both markets. European leveraged loans and CLOs are the second largest market, followed by US middle market loans and CLOs. Each of these markets has different challenges facing them, but there are also similarities in structures, market participants, and market forces that can benefit from shared experiences. Finally, there is the potential for a CLO market to cross over to Asia to focus on Asian credit issuance. The US broadly syndicated loan and CLO markets can serve as a benchmark for the future development of global loan and CLO markets. TOPICS:CLOs, CDOs, and other structured credit, global markets, developed markets, emerging markets Key Findings • Growth in the US leveraged loan market has been supported by sustained, but moderate, GDP growth over the past decade and monetary policy both domestically and intentionally has encourage investment in the US. • Prevalent features of the current leveraged loan market, like robust secondary market trading and covenant-lite loan structures resulting from evolution of the leveraged loan market evolving and convergence with the high yield bond market. • US capital markets continue to evolve with CLOs and private credit providing more sources of liquidity for corporate issuers.

CLO Conference Notes 2019: from the Information Management Network 8th Annual Investors Conference on CLOs and Leveraged Loans

1. Mark Adelson 1. is the editor of The Journal of Structured Finance at Pageant Media in New York, NY. (m.adelson{at}pageantmedia.com) <!-- --> 1. To order reprints of this article, please contact David Rowe at d.rowe{at}pageantmedia.com or 646-891-2157. TOPICS: [Mutual fund performance

CLO Conference Notes 2018: from the Information Management Network 7th Annual Investors Conference on CLOs and Leveraged Loans

The report covers 15 sessions from the 7th Annual Investors Conference on CLOs and Leveraged Loans, which was held May 23–24, 2018, at the Sheraton New York Times Square Hotel. The covered sessions include the three general sessions, the two keynote addresses, and the two pre-conference workshops. The issues that received the most attention in the sessions were (1) the replacement of LIBOR, (2) the elimination of US risk retention requirements for most CLOs, (3) manager tiering, and (4) weaker loan documentation. The event attracted nearly 1,900 registered attendees and the prevailing mood was one of a strongly positive outlook for the CLO sector.

LIBOR Floors in Leveraged Loans

I examine the use of LIBOR floors in U.S. leveraged (syndicated) loans. These options, rare prior to 2008, provide a minimum interest rate on these otherwise floating rate loans. This contract design is consistent with theory suggesting lenders prefer more fixed rate assets while interest rates are low in order to cover their fixed costs. Two main findings support this rationale. First, borrowers seeking to extend loans between 2009 and 2016 were able to attract 34% more principal from lenders if a floor was added, suggesting demand for floors originated from the supply of credit. Second, banks that participated in floor-adjusted credit lines had significantly higher fixed costs than did banks in purely floating rate facilities. Floors are concentrated in institutional facilities, in particular those that are most likely to trade in the secondary market. This is consistent with cost savings associated with embedded floors over those obtained through third-parties when expected trading volume is high. Consistent with their theoretically higher interest rate sensitivity, loans that embed floors are more likely to include call protection, in the form of cancellation and upfront fees. Floors represent a significant component of loan pricing, contributing three to five times as much as upfront fees to total lender compensation.

CLO Conference Notes 2017

The report covers selected sessions of the 6th Annual Investors Conference on CLOs and Leveraged Loans. The event was held in New York on May 24–25, 2017. There were 1,603 registered attendees. The prevailing mood was upbeat, buoyed by the prospect for regulatory relief and solid deal flow in the early part of the year. The report covers 14 sessions, including the general sessions on the outlook for the leveraged loan market and the outlook for the CLO market. <b>TOPICS:</b>CLOs, CDOs, and other structured credit, financial crises and financial market history

Long-Run Relationship between Default Rates and Macroeconomic Variables in the U.S. Leveraged Loan Market

This article examines and ascertains a long-run relationship of leveraged loan defaults rates and macroeconomic variables in the United States. It identifies factors in the economic environment that have a significant impact on the development of leveraged loans. The author uses a vector error correcting model to elaborate the interdependencies among industrial production, credit spreads, differences between credit and leveraged loan spreads, the stock market, and the number of defaults of the S&P Leveraged Loan Index. The time series is based on 156 months between January 1999 and December 2011. Credit spreads, differences in loan and bond spreads, and the stock market have a positive impact on default rates, whereas industrial production shows a negative sign. All factor variables are highly significant aside from the stock market.

Participation in Leveraged Loans: It's Not Just About Credit Risk

Even as banks have decreased their exposure to residential mortgage loans since 2008, bank exposure to leveraged lending has risen dramatically. The $1 trillion total asset leveraged loan market poses a significant and growing source of credit risk to U.S. depository institutions and investors. Further, the full extent of the risk posed by leveraged loans as an asset class is not adequately understood by investors, regulators, and the markets as a whole. In addition to the well-documented credit risk posed by leverage loans, KBRA believes that the widespread practice of participating shares of leveraged loans represents a significant additional risk to financial institutions and other investors from this asset class.