Collateralized Loan Obligation (CLO) funds purchase the largest amounts of U.S. leveraged loans. However, they can expect to see a large sell off as investors are looking to avoid the current stresses that the economy is experiencing. Billions of dollars have already been pulled out of loan funds this year by investors. According to a team of analysts at Bank of America (NYSE: BAC) Merrill Lynch led by Chris Flanagan, the "tightening financial conditions, tepid loan technicals, and cautionary rhetoric" have all contributed to the intensifying problems.
A CLO is a security that can be purchased, made up of, or backed, by a pool of debt. These are usually corporate bonds with "junk bond" credit ratings or leveraged buyouts made by private equity firms. They are similar to the Collateralized Mortgage Obligations (CMO) which were a catalyst of the 2008 financial crisis.
According to data compiled by Bloomberg, loans tied to more than 50 companies have lost approximately 10% points of face value in just three months. These include companies in sectors such as energy, consumer discretionary, health care, technology, and communications. Lenders can in most cases get just two-thirds of their investments back if they try to sell. This reflects shifting sentiment regarding speculations of a recession. Andrew Sveen, co-director of bank loans at Eaton Vance Management pointed out that, "People want the well-performing loans, and are more wary of taking chances on the situations that have turned negative".
Once loans become downgraded, this can trigger a sell by managers who are limited from holding bonds that fall below a certain ratings threshold. Most CLOs are limited to no more than 7.5% of their portfolios in loans rated CCC.
CLOs have also come under the radar of regulators and politicians. Senator Elizabeth Warren, candidate for U.S. presidency, issued a letter to the Securities and Exchange Commission (SEC) criticizing it for having "failed to use regulatory tools" which it was graded to limit and keep under control the inflated bond ratings (which were a catalyst of the 2008 recession). She also specifically addressed CLOS, stating "I am especially concerned about collateralized loan obligations (CLOs), given the rapid growth of CLOs and the lack of appropriate responses from federal agencies, including the SEC. These securitizations have helped enable increased leveraged loans that are generally poorly underwritten and include few protections for lenders and investors, which creates significant risk to the financial system and the American economy."