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Brian Chappatta

These CLOs Lie in Wait for the Powder Keg to Blow

Funds with greater ratings flexibility are ready to buy downgraded leveraged loans on the cheap.

It’s better to be off to the side to pick up the pieces.

It’s better to be off to the side to pick up the pieces.

Photographer: Alain Jocard/AFP/Gettty Images

Ask fund managers about their worst nightmare, and almost surely it’s some variation of being a “forced seller” in a weak market. Investors get panicky, rush to pull their money out and managers have no choice but to offload securities at fire-sale prices to raise cash.

One of the benefits of running a collateralized loan obligation is that the constant specter of redemptions is nonexistent. The money is raised up front by selling tranches of bonds split up by credit rating, and then the manager purchases a swath of leveraged loans to pay those investors. The CLO securities can change hands in the secondary market, but the manager doesn’t have to worry about being on the hook for unloading loans if some people want out.