Currencies May See Wild Swings if Slow Growth Breaks CLO Market

The IMF, central banks and politicians have warned about the proliferation of collateralized loan obligations (CLOs) and the threat they pose to the global financial system. Currency markets may be battered by breakneck volatility if a slowdown in global economic growth triggers a collapse in this fragile market.

WHAT ARE COLLATERALIZED LOAN OBLIGATIONS (CLOS)?

Collateralized loan obligations (CLOs) are a structured credit instrument, similar to a collateralized debt obligation (CDO), the infamous financial instrument at the center of the Great Recession in 2008. Similar to CDOs, it involves the process of securitizing various debt obligations and then redistributing the cash flows to all participants who bought into the security.

However, CLOs don’t deal with mortgage loans but are rather composed of bundled corporate debt. Within the security are various levels or “tranches” that investors can buy into that cater to the risk appetite each market participant is willing to tolerate. While the top tranches – which generally have higher ratings (e.g. AAA) – get paid out first, the reward is smaller because the level of risk is comparatively lower.

The lower-level tranches get paid out last and generally have lower ratings – e.g. BB – but the payout is higher. A premium offered to investors who are willing to take on additional risk. Some of the more financially-precarious levels offer returns as high as 20 percent, but the associated risk is proportionately higher.

Unlike fixed-income securities, CLOs are packaged with floating-rates yields. Meaning, if prevailing interest rates rise, the yield on the underlying assets will advance accordingly. In this regard, investors have found CLOs to be a great hedge against rising interest rates, a feature not offered in traditional fixed income securities. This might partially explain why popularity in CLOs has grown as global credit conditions tighten.

However, given the recent global slowdown caused by a slower rate of expansion in China, greater political and economic uncertainty in Europe and the pain caused by trade wars, it is possible central banks may pivot toward adopting a more accommodative monetary policy.

WHAT RISKS DO CLOS POSE TO THE FINANCIAL SYSTEM?

While defaults on CLOs have been relatively low, the growing demand for this instrument has caused a deterioration in underwriting standards. This has led to an increased issuance of what are called “leveraged loans” – high-risk debt obligations. These are often made to firms that have an unfavorable debt-to-assets ratio that puts the lender at a greater risk of suffering a default and reporting a loss on their balance sheet.