Are CLOs a Systemic Risk?

Market Blog By LPL Research 

 

What is a Collateralized Loan Obligation (CLO)?

Collateralized loan obligations (CLO) are portfolios of leveraged loans, a type of below-investment-grade loan usually taken out by more heavily indebted companies. Each CLO is divided into a series of tranches with different degrees of risk. The more senior tranches receive their interest payments first, and therefore, have a higher credit rating. Since the loans carry a floating rate of interest, CLOs provide investors with better protection from inflation and rising interest rates than bonds that have fixed payments.

Who typically invests in CLOs?

Banks, insurance companies, hedge funds, mutual funds, and other sophisticated investors are the primary investors in the CLO market. However, each of these investors may target different tranches of the CLO structure. For instance, banks almost exclusively invest in the AAA-rated tranche, the highest rating available, due to bank regulations that require higher quality investments. Meanwhile, speculative investors, such as hedge funds, will target the riskier portions of the portfolio seeking higher returns.

Do CLOs pose a systemic threat like other similar products did in 2008?

CLOs are often compared to another securitized product—collateralized debt obligations (CDO)—that posed significant risks to the financial system in 2008. We don’t believe, however, that CLOs today pose the same kind of threat. Unlike CDOs, which generated sometimes exotic offshoot derivatives products—such as  CDOs made up of CDOs—there is little to no use of derivatives with CLOs. CDO derivatives amplified the financial system’s total exposure to the CDO market in 2008.

Further, while systemically important financial institutions do invest in CLOs, their primary exposure is to the AAA-tranches, which historically have had very little default risk. In fact, according to S&P Global Ratings, no AAA tranche of a CLO has defaulted to date, with only one default occurring to the AA tranche—even during the financial crisis of 2008–09.

While the effects of COVID-19 create very real risks to the global economy, we don’t think the CLO market poses a systemic risk, especially given the historical stimulus measures that have been implemented to contain the economic risk and accelerate the recovery. Bank balance sheets have been strengthened significantly since the financial crisis, which puts them in a better position to handle additional shocks that may come.

We will continue to follow developments in the CLO market and credit markets more broadly for signs of deterioration.

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This Research material was prepared by LPL Financial, LLC.

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