Intermediary Frictions and the Corporate Credit Cycle: Evidence From CLOs

Abstract

I quantify the contribution of intermediary agency frictions to the cyclicality of lending
by non-bank intermediaries. I focus on collateralized loan obligations (CLOs), which
are actively managed closed-end funds that provide about one-third of the credit to
speculative-grade corporations in the US and are particularly cyclical in their lending.
For variation in agency frictions, I exploit an institutional feature that leads to variation
in CLOs’ discretion to trade their assets. I document that CLOs’ cost of debt contains
significant compensation for agency problems. Agency problems intensify in bad times
when aggregate volatility rises, raising CLOs’ cost of debt, and reducing the issuance of
new CLOs. This affects real outcomes of CLO-dependent firms. To mitigate this effect,
CLOs issued in volatile periods restrict their discretion in trading, which, however, also
reduces their alpha. Calibrating a novel intermediation model to these reduced-form
estimates, I find that more than half of the steep fall in CLO issuance during volatile
periods is due to agency frictions. A counterfactual analysis reveals that without CLOs
restricting their discretion in volatile periods, CLO issuance would be substantially
more cyclical and real effects on speculative-grade firms correspondingly larger.

Keywords: Credit cycle, intermediary frictions, agency frictions, CLOs, non-banks

JEL Classification: G23, E32, E44, G01