Demystifying CLO Demand for Leveraged Loans

Leveraged loans have beneficial characteristics that make them distinct within the fixed income universe: they’re floating-rate instruments, senior in a company’s capital structure, secured by collateral and tend to have short average lives. Those traits make them attractive to investors seeking yield potential with typically lower volatility, and those investors have different options for accessing the loan market. Some institutions invest through separately managed accounts or commingled vehicles, while individuals might choose to access the market through mutual funds or exchange-traded funds. But the biggest source of demand for loans, especially over the last year, has been collateralized loan obligations, or CLOs. A wide variety of investors come together to form each of these special purpose vehicles, and they help provide stability to the loan market through multi-year commitments. Representing 59% of the leveraged loan investor base at September 30, 2020, and 72% of new loan purchases for the 12 months ending September 30, 2020, it’s important to understand how CLO managers behave and what incentives they have.

CLOs must adhere to tested covenants

CLO managers buy the same types of loans that other loan investors buy, but they must adhere to a strict set of tested covenants that help ensure diversification and other requirements While CLO managers are seeking a high total return for the investors who own the equity of the structure, they cannot breach the indenturei guidelines without the prospect of the structure being downgraded. Therefore, in addition to the credit research work that must be done to understand each company and the prospects for being repaid, each loan must be evaluated within the portfolio overall to make sure that all of the guidelines are met. That imperative can lead CLO managers to behave in ways that impact the loan market overall. We believe CLO behavior is a factor that all loan managers should consider when making their own credit selections.