Abstract

There are two major institutional investors in the syndicated loan market: collateralized loan obligations (CLOs) and loan mutual funds. CLOs are closed-end funds while loan funds are openend funds that issue claims that are redeemable on demand. In this paper, we examine whether CLOs provide arbitrage capital that contributes to the resilience of loan funds. We find that CLOs act as shock absorbers, providing liquidity through par building trades when loan funds experience large outflows. However, CLO-provided liquidity is limited to par build eligible loans, leading to potential flow-induced fire sales among par ineligible loans.

Abstract

Reputational capital is a frequently cited attribute of private equity transactions. In this paper we construct a simple model to illustrate the relationship between reputational capital, covenants and loan spreads in the leveraged loan market. Our model predicts that reliance on reputational capital varies inversely with a sponsor’s past loan performance and the efficiency of the enforcement formal contracts terms. Our model also predicts that for sponsored deals, spreads will be lower on Cov-Lite loans than loans with maintenance covenants. Using a large sample of leveraged loans originated between 2005 and 2018, we find evidence consistent with these predictions.

Abstract

Whether maturity transformation exposes banks to interest rate risk depends in part on the effectiveness of bank deposits as a hedge against interest rate shocks. In this paper, we provide evidence that, despite an increase in the average maturity of bank assets, the duration of bank equity declined in the post-financial crisis era. We argue that one factor contributing to the decline was an increase in the average duration of deposits due to a decline in deposit betas when interest rates are low. The dynamics nature of the duration of deposits also explains why deposits provided a poor hedge against recent rate hikes. Overall we find that variable deposit betas combined with mortgage lending leads to a negative convex relationship between the value of bank equity and interest rates.

Abstract

The growth of mutual fund investing in private and thinly traded instruments has raised concerns regarding the valuation practices of fund managers. In this paper we examine the valuation practices of loan mutual funds and analyze the relationship between indicators of discretionary pricing and investment flows. Overall, we find evidence of return smoothing by loan funds. In addition, we find greater return smoothing during periods of market illiquidity when the incentives inflate valuations are likely the greatest. Finally, we find that smoothed returns affect investment flows into retail but not institutional oriented funds.

Abstract

We investigate the effectiveness of security in protecting creditors from dilution arising from litigation and other non-debt related claims; claims we refer to as exogenously unsecured. Consistent with this security affording greater protection from dilution, we find that disclosures of litigation claims are associated with a significant increase in the spread between a firm’s unsecured and secured and debt claims. More important, we find that the propensity of material litigation claims is negatively related to firms’ reliance on secured debt. Our findings are consistent with the notion that collateral provides protection from litigation claims, and thus is an additional motivation for firms to borrow on a secured basis, even in circumstances where covenants on unsecured claims might be effective in mitigating the agency costs of debt.

Abstract

Recent trends in the leveraged loan market towards weaker creditor protection have raised concerns regarding the credit risk of loans originated and then sold to Collateralized Loan Obligations (CLOs). Relaxed due diligence on the part of CLO managers in the acquisition and sale of leveraged loans has the potential to exacerbate unmodeled systemic risk, or frailty. In this paper I examine a channel through which CLOs may contribute to the frailty posed by these trends: correlated trading by CLO managers when they buy or sell a loan in the secondary markets. Consistent with a moral hazard hypothesis, the propensity to engaging in correlated trading is negatively and significantly associated with the CLO performance. Consistent with its potential to exacerbate frailty, correlated trading is positively related to the correlated holdings of collateralized assets. I also provide evidence that CLO managers engage in correlated trading due to reputational concerns. The risk retention rule that increases CLO managers skin in the game significantly reduced correlated trading.