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How a Deluge of Downgrades Could Sink the CLO Market


It takes a large dose of Wall Street alchemy to create the structured finance products known as CLOs, which fund much of corporate America. So collateralized loan obligations naturally came under particular scrutiny as the scale of the coronavirus pandemic became clear in March. Since then, many pockets of the financial markets have rebounded feverishly. But CLO investors are still bracing for the worst: Many expect a cascade of downgrades that will ripple through these complex securities, testing the internal mechanisms designed to protect them.

As CLO managers make their required disclosures over the next several months, the scale of the problem is expected to unfold. By mid April, some analysts were expecting as many as 1-in-3 CLOs may have to limit payouts to holders of the riskiest and highest-returning parts of their structures. Others say the pain could quickly spread to less risky tranches, too. There were warning signs: Key parts of CLOs were conspicuously absent from the rally that lifted U.S. stocks in April. Lower-rated bonds in the almost $700 billion market remained deeply depressed, typically fetching less than 70 cents on the dollar.