Consequences of CLO Portfolio Constraints

Abstract

We investigate the relation between portfolio constraints (tests) that Collateralized Loan Obligations (CLOs) have to pass monthly, CLO managers’ loan trading choices and CLO equity returns. We find that stringent portfolio constraints are positively associated with the influence of CLO junior noteholders and tight CLO market conditions. We document that CLOs with restrictive tests have higher portfolio turnover, rebalancing and diversification, and hold loans for shorter periods, suggesting that managers of constrained CLOs actively administer loan portfolios to alleviate credit losses and costly test violations. We further show that managers of constrained CLOs respond to borrower news differently by trading loans to avoid reporting credit losses and to comply with the CLO tests rather than to generate profits from trading. Last, we examine the economic effects of restrictive portfolio tests and find that these constraints are associated with lower CLO equity returns. Our evidence supports the argument that portfolio constraints lead to divergent trading choices and ultimately to different levels of CLO performance.

Keywords: CLOs, securitization, portfolio tests, equity returns, credit risk, asset management

JEL Classification: M41, G23