The collateralized loan obligation, or CLO, is one of those funky creations of Wall Street wizardry that have been around for decades. Just like its close cousin, the much-castigated collateralized debt obligation, it’s a tool used to package a bunch of high-risk debt together—mortgage bonds for CDOs, corporate loans for CLOs—so they can be easily sold to investors hungry for juicy returns.
Unlike the CDO, the CLO made it through the financial crisis largely unscathed and has boomed in the decade since. Fueled by the unprecedented $3.5 trillion wave of private equity buyout deals during the past decade, and rock-bottom U.S. interest rates that only stoked investors’ willingness to gamble on riskier assets, the CLO market has more than doubled since 2010, to $660 billion. By providing abundant cheap funding to the less creditworthy end of the market, it’s helped grease the wheels of the longest economic expansion in U.S. history.
But as odds of a recession in 2020 grow, ratings downgrades could cause a stampede of selling by CLOs, potentially cutting off scores of companies from additional credit, preventing them from refinancing their debt, and threatening their survival. “If there’s no price support for lower-rated loans, that will be reflected over time in new issue and refinancing markets, which may mean the lowest-quality borrowers lose access to capital markets,” says Andrew Curtis, the head of Z Capital Group‘s credit arm, which manages CLOs and other funds. Volatility in the market could spill over into the high-yield bond market and even send ripples into the broader economy that could deepen or prolong any recession.
The heart of the problem is the very same phenomenon that fueled the growth in the market in the first place: those ultralow rates. A CLO begins with what Wall Street...