Doubling Down on a Future Recession, Enhanced CLOs are on the Rise

Posted on August 9th, 2019 at 5:15 PM
Doubling Down on a Future Recession, Enhanced CLOs are on the Rise

With rumors of a looming recession and resulting volatility in debt prices, money managers are looking to cash in on future debt downgrades by holding “enhanced” collateralized loan obligation (“CLO”) portfolios that contain a much larger share of low-credit rated loans than the typical CLO.  Since 2011, B or B-minus rated loans have increased significantly. A sign, many investors believe that, even with a slight recession, many of those loans will be downgraded to C ratings.

The standard CLO holds, at most, 7.5% of its loan portfolio in triple-C rated loans. Some money managers now utilize this enhanced CLO strategy that allows them to hold up to 50% of their assets in triple-C loans. The strategy would come into action with a market downturn, causing the typical CLOs, with the 7.5% limit, to dump a major portion of their existing debt portfolio due to the 7.5% restrictions.  In turn, the enhanced CLOs would have the opportunity to buy the downgraded loans at steep discounts. This increased volatility of triple-C rated debt will drive prices lower, arguably making them a good investment.

CLOs that can buy more triple-C loans are risky. Although a high-risk strategy, money managers claim they are being selective in the triple-C rated loans they buy. For example, they pledge to buy loans with covenants attached, which require borrowers to meet specific standards of financial fitness.

Regardless of how this strategy plays out, the use of this “enhanced” CLO strategy indicates the negative sentiments on the economy and expectations of a downturn. 


Related Attorneys: James J. Eccleston

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