The authors discuss the economics of collateralized loan obligations and the extent to which they may be vulnerable to the economic downturn caused by the COVID-19 pandemic.
Since the financial crisis of 2008, the amount of corporate debt outstanding in the United States has experienced a marked increase, driven by ample availability of credit and investors’ growing appetite for holding debt. Collateralized Loan Obligations (CLOs) facilitate growth in the corporate debt market by acting as some of the biggest buyers of leveraged loans. These leveraged loans are loans to mid-size and large companies that have significant amounts of debt outstanding and are rated below investment grade.
Recent market movements and rating agency actions suggest that, as a result of their exposure to highly indebted companies, today’s CLOs are potentially vulnerable to the systemic economic shock caused by the COVID-19 global pandemic. In February and March 2020, market prices of leveraged loans declined significantly. While these prices have seen a substantial recovery since, a number of rating actions have been announced. Some market participants are expressing concern that leveraged loans may experience increased defaults that lead to CLO losses in the future, especially if the current COVID-19 pandemic crisis results in a prolonged economic recession.
In this article, authors Yan Cao, Paul Zurek, and Manuel Vasconcelos discuss the economics of CLOs, the role of credit ratings, the evolution of the market over time, and why and how CLOs could be vulnerable to the economic downturn caused by the crisis.
This article was originally published by Westlaw in June 2020.
The views expressed herein do not necessarily represent the views of Cornerstone Research.