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Introduction
Whenever an entity lends money to a borrower, it is exposed to credit risk, the possibility of a loss resulting from a borrower’s failure to repay a loan or meet contractual obligations.
Evidently, credit risk cannot be homogeneous amongst debtors, as borrowers’ credit history, business models and financial situations greatly differ from one another. Different borrowers are broadly assigned different levels of credit worthiness, which determine the borrowers’ credit rating, quantitative and qualitative assessments on the probability that the borrower will, partially or completely, default on its debt. Higher credit ratings entail lower risk, lower credit ratings are associated with higher probability of default. Credit ratings are issued by independent third parties known as credit rating agencies (CRAs).
It is important to note, however, that these rating agencies do have misaligned incentives and conflicts of interests as they are directly paid by the issuer of the bond (the borrower).
If interested, the reader can refer to Dealing with the conflicts of interest of credit rating agencies: a balanced cure for the disease. We will not delve into the intricacies linked with regulating the behavior of CRAs nor will we analyze the conflicts of interests and the problems associated with asymmetric information between lenders and borrowers. Rather, this insight will be dedicated to analyze credit risk differences between Collateralized Loan Obligations and traditional fixed income instruments, notably bonds.
CLOs vs corporate bonds
Broadly speaking, credit ratings can be subdivided into two main macro categories:
- Investment grade ratings, which identify more credible borrowers
- Speculative grade ratings, which identify those borrowers more likely to default.
In finance every risk has a price. This is because any rational investor dislikes risk and wants to be compensated for any that he/she takes on. In this context, the higher the credit risk, the higher must be the risk premium required by investors: as a consequence, speculative grade investments offer higher interest payments against higher probability of default.
However, not every debt instrument is exposed or reacts the same way to a given level of credit risk. Indeed, as noted by Mark Wahrenburg, Andreas Barth, Mohammad Izadi and Anas Rahhal (Risk Factors of CLO’s and Corporate Bonds) “Structured products like collateralized loan obligations (CLOs) tend to offer significantly higher yield spreads than corporate bonds with the same rating. At the same time, empirical evidence does not indicate that this higher yield is reduced by higher default losses of CLOs. The evidence thus suggests that CLOs offer higher expected returns compared to corporate bonds with similar credit risk. “ This is an important difference that, however, is relatively easy to explain.
By nature, CLOs incorporate hundreds of loans or bonds in their portfolio and benefit from diversification and active management. So, they are inherently positioned to mitigate the impact of individual defaults and market fluctuations. The synergy of diversification and active management allows CLOs to navigate the complexities of credit risk in a way that traditional corporate bonds may not. As evidence, we provide the data by S&P 500 Global that compares Speculative Grade CLOs and Bonds default rates.
If we extend the same line of reasoning to account for the issuance of investment grade CLOs as well, we obtain a very similar result: the U.S annual default rate of all U.S rated CLOs is much lower than that of all U.S. rated corporate bonds.
On the contrary, because of the interconnectedness of the underlying assets in the portfolio, CLOs are exposed to higher systemic risk than the single corporate bond. This, at least in terms of financial theory, accounts for the difference in expected returns.
Furthermore, credit rating agencies on a periodic basis revise and adjust the ratings of bonds and CLOs. Bond ratings are revised according to new quantitative and qualitative assessments of the financial stability of the issuer, and CLOs assessment depends on quantitative and qualitative assessment of the underlying portfolio of loans. Once these new assessments are carried out, CRAs either upgrade, downgrade or confirm the debt instrument credit worthiness.
Again, because of the nature of the instrument, CLOs have historically demonstrated more resilience to downgrades than comparable corporate bonds. The graph below shows this relationship. The only exception was in the period 2009-2011 when, as noted by S&P global post-crisis collateral deterioration and revised rating methodology can explain the spike in downgrades.
Conclusion
In conclusion, in this insight we have explored an interesting dynamic that makes CLOs and corporate bonds different from each other in terms of credit risk. This difference can be explained in terms of active management, diversification measures and different systemic risk considerations and we have demonstrated how, historically, CLOs have shown to be more resilient to credit downgrades and have exhibited lower default rates than comparable corporate bonds. This factor has contributed to rendering this structured financial product more appealing to investors.
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