Leveraged Loans and Collateralized Loan Obligations (CLOs): Recent Developments and Policy Actions
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INSIGHTi
Leveraged Loans and Collateralized Loan
Obligations (CLOs): Recent Developments
and Policy Actions
June 11, 2020
Leveraged loans are a type of corporate debt extended to highly indebted companies. Borrowers often use
leveraged loans to fund general operations or finance private equity firms’ leveraged buyouts. Some
leveraged loans are packaged into collateralized loan obligations (CLOs) through securitization.
Leveraged loan and CLO markets’ risk profile and rapid growth have drawn policy attention in recent
years. Some are concerned that, when under stress, potential credit rating downgrades and escalating
defaults in these markets could amplify financial system vulnerability.
During the COVID-19-induced economic downturn, the heightened market stress and reduced corporate
earnings have led to performance deterioration in leveraged loans and CLOs. The related price decline is
more evident for the lower-rated CLO tranches. The pricing reflects the investors’ expectation that the
relevant loss absorption structures may protect senior tranches while eroding certain equity and
mezzanine tranches. The Federal Reserve (Fed) announced support for some highest-rated CLOs,
benefiting certain newly issued CLOs. This Insight examines selected performance measures of leverage
loans and CLOs and the related federal government interventions.
Leveraged Loan Market Growth
Since the 2007-2009 financial crisis, the leveraged loan market has increased, reaching $1.2 trillion
(Table 1). As the market has grown, certain creditor protections called covenants—terms in the loan
contract that allow the creditor to monitor the borrower and take certain corrective actions before a
payment default occurs—have become less prevalent in many leveraged loan contracts.
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IN11421
CRS INSIGHT
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Table 1. Leveraged Loan Market Size and Covenant-Lite Share
Source: S&P Global.
Notes: S&P/Loan Syndications and Trading Association leveraged loan Index. Not inflation adjusted. Covenant-lite means a
loan agreement has fewer covenants.
CLO Loss Absorption Structure
CLOs are typically supported by a diverse collateral pool. A pool’s cash flows are restructured and sold in
separate tranches (Figure 1). The different tranches are assigned different payment priorities, so some
tranches will incur losses before others. This tranche structure redistributes the loan portfolios’ credit risk.
The equity tranche would be the first in line to absorb losses from the collateral pool, followed by other
lower credit rating CLO debt tranches (mezzanine). Lower CLO tranches receive higher yield to
compensate for the risks taken.
Figure 1. Typical Collateralized Loan Obligation (CLO) Structure
Source: Guggenheim Partners; Congressional Research Service.
Since the 2007-2009 financial crisis, the CLO subordination has increased somewhat to give additional
protection to senior tranches. For example, a typical AAA-rated CLO tranche in 2018 would suffer losses
only after the value of the underlying collateral fell by roughly 40%, as opposed to the roughly 30%
declines that would have triggered losses in 2007 (Figure 2).
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Figure 2. Changes in Collateralized Loan Obligation Subordinated Structure
Source: Financial Stability Board.
The higher- and lower-rated CLO tranches have different investors. Although banks are major investors in
AAA-rated CLO tranches, the asset management industry represents the largest investor base for higher-
risk CLOs (Figure 3).
Figure 3. U.S. Collateralized Loan Obligation Investor Base
(percentage; as of 2019)
Source: International Monetary Fund.
Recent Market Performance
During the COVID-19 pandemic, many risk and pricing measures (e.g., loan defaults, downgrades,
earnings leverage, covenant amendments, and price movements) for leveraged loans and CLOs have
deteriorated.
Increased Defaults and Credit Rating Downgrades
Loan default rates are associated with borrowers missing payments or filing for bankruptcy. As of May
2020, leveraged loan default rates have reached the highest in recent years to more than 3% (Figure 4).
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The ratio of credit rating downgrades to upgrades for U.S. leveraged loans has also reached a record high
(Figure 5), suggesting credit quality deterioration.
Figure 4. U.S. Leveraged Loan Default Rate
(as of May 21, 2020)
Source: S&P Global.
Notes: LTM = last 12 months. The large spike in early periods was caused by a $20 bil ion single-borrower default of
Energy Future Holdings (TXU).
Figure 5. U.S. Leveraged Loan Downgrades to Upgrades Ratio
(as of April 30, 2020)
Source: S&P Global.
Increased Debt-to-Earnings Leverage
Leveraged loans received their name from borrowers having high debt-to-earnings “leverage,” typically
measured by the debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization) ratio.
The higher the leverage, the lower the companies’ payment capabilities, and the more risk to investors.
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Leveraged loans’ debt-to-EBITDA ratio has risen substantially since 2019, even before the pandemic,
(Figure 7) largely because of a significant decline in firms’ earnings (Figure 6).
Figure 6. U.S. Leverage Loan Issuer Quarterly EBITDA Growth Rate
(as of March 31, 2020)
Source: S&P Global.
Note: EBITDA = earnings before interest, taxes, depreciation and amortization.
Figure 7. Average Leverage of Outstanding U.S. Leveraged Loans
(as of March 31, 2020)
Source: S&P Global.
Record Covenant Relief Amendments
When borrowers are in trouble, they tend to negotiate with lenders for relief from covenants restricting
their ability to exceed certain limitations. As of April 2020, borrowers and lenders are modifying loan
covenants in record numbers (Figure 8).
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Figure 8. Number of U.S. Leveraged Loan Covenant-Relief Amendments
(as of May 31, 2020)
Source: S&P Global.
Price Movements
CLOs experienced sharp selloffs in March 2020. Although higher-rated CLOs rebounded to a large extent,
lower-tranche CLOs, which are designed to absorb losses for collateral pools, did not recover at the same
level (Figure 9 and Figure 10).
Figure 9. Price Performance Examples: Funds Invested in Lower-Tranche Collateralized
Loan Obligations
(as of mid-May 2020)
Source: Bloomberg.
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Figure 10. Leveraged Loan Collateralized Loan Obligation Rebound: Lower-Rated Versus
Higher-Rated
Source: Credit Suisse, Bloomberg.
Federal Government Liquidity Intervention
The Fed—sometimes with support from the Treasury Department—has established
several emergency lending facilities to provide liquidity to key capital markets segments. On
April 9, 2020, the Fed expanded the Term Asset-Backed Securities Loan Facility (TALF) to
provide support for leveraged loan and CLO markets in addition to other asset-backed security
markets. Certain senior tranche AAA-rated static CLOs could qualify under TALF. Static CLOs
are CLOs that do not include a period of reinvestment of collateral proceeds. The eligible CLOs
must be newly issued, on or after March 23, 2020. The Fed expanded TALF again on May 12,
2020, to include CLOs that contain leveraged loans from earlier periods, including those
leveraged loans originated on or after January 1, 2019.
Author Information
Eva Su
Analyst in Financial Economics
Disclaimer
Congressional Research Service
8
This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan shared staff
to congressional committees and Members of Congress. It operates solely at the behest of and under the direction of
Congress. Information in a CRS Report should not be relied upon for purposes other than public understanding of
information that has been provided by CRS to Members of Congress in connection with CRS’s institutional role.
CRS Reports, as a work of the United States Government, are not subject to copyright protection in the United
States. Any CRS Report may be reproduced and distributed in its entirety without permission from CRS. However,
as a CRS Report may include copyrighted images or material from a third party, you may need to obtain the
permission of the copyright holder if you wish to copy or otherwise use copyrighted material.
IN11421 · VERSION 1 · NEW
INSIGHTi
Leveraged Loans and Collateralized Loan
Obligations (CLOs): Recent Developments
and Policy Actions
June 11, 2020
Leveraged loans are a type of corporate debt extended to highly indebted companies. Borrowers often use
leveraged loans to fund general operations or finance private equity firms’ leveraged buyouts. Some
leveraged loans are packaged into collateralized loan obligations (CLOs) through securitization.
Leveraged loan and CLO markets’ risk profile and rapid growth have drawn policy attention in recent
years. Some are concerned that, when under stress, potential credit rating downgrades and escalating
defaults in these markets could amplify financial system vulnerability.
During the COVID-19-induced economic downturn, the heightened market stress and reduced corporate
earnings have led to performance deterioration in leveraged loans and CLOs. The related price decline is
more evident for the lower-rated CLO tranches. The pricing reflects the investors’ expectation that the
relevant loss absorption structures may protect senior tranches while eroding certain equity and
mezzanine tranches. The Federal Reserve (Fed) announced support for some highest-rated CLOs,
benefiting certain newly issued CLOs. This Insight examines selected performance measures of leverage
loans and CLOs and the related federal government interventions.
Leveraged Loan Market Growth
Since the 2007-2009 financial crisis, the leveraged loan market has increased, reaching $1.2 trillion
(Table 1). As the market has grown, certain creditor protections called covenants—terms in the loan
contract that allow the creditor to monitor the borrower and take certain corrective actions before a
payment default occurs—have become less prevalent in many leveraged loan contracts.
Congressional Research Service
https://crsreports.congress.gov
IN11421
CRS INSIGHT
Prepared for Members and
Committees of Congress
link to page 2 link to page 3
Congressional Research Service
2
Table 1. Leveraged Loan Market Size and Covenant-Lite Share
Source: S&P Global.
Notes: S&P/Loan Syndications and Trading Association leveraged loan Index. Not inflation adjusted. Covenant-lite means a
loan agreement has fewer covenants.
CLO Loss Absorption Structure
CLOs are typically supported by a diverse collateral pool. A pool’s cash flows are restructured and sold in
separate tranches (Figure 1). The different tranches are assigned different payment priorities, so some
tranches will incur losses before others. This tranche structure redistributes the loan portfolios’ credit risk.
The equity tranche would be the first in line to absorb losses from the collateral pool, followed by other
lower credit rating CLO debt tranches (mezzanine). Lower CLO tranches receive higher yield to
compensate for the risks taken.
Figure 1. Typical Collateralized Loan Obligation (CLO) Structure
Source: Guggenheim Partners; Congressional Research Service.
Since the 2007-2009 financial crisis, the CLO subordination has increased somewhat to give additional
protection to senior tranches. For example, a typical AAA-rated CLO tranche in 2018 would suffer losses
only after the value of the underlying collateral fell by roughly 40%, as opposed to the roughly 30%
declines that would have triggered losses in 2007 (Figure 2).
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Congressional Research Service
3
Figure 2. Changes in Collateralized Loan Obligation Subordinated Structure
Source: Financial Stability Board.
The higher- and lower-rated CLO tranches have different investors. Although banks are major investors in
AAA-rated CLO tranches, the asset management industry represents the largest investor base for higher-
risk CLOs (Figure 3).
Figure 3. U.S. Collateralized Loan Obligation Investor Base
(percentage; as of 2019)
Source: International Monetary Fund.
Recent Market Performance
During the COVID-19 pandemic, many risk and pricing measures (e.g., loan defaults, downgrades,
earnings leverage, covenant amendments, and price movements) for leveraged loans and CLOs have
deteriorated.
Increased Defaults and Credit Rating Downgrades
Loan default rates are associated with borrowers missing payments or filing for bankruptcy. As of May
2020, leveraged loan default rates have reached the highest in recent years to more than 3% (Figure 4).
link to page 4
Congressional Research Service
4
The ratio of credit rating downgrades to upgrades for U.S. leveraged loans has also reached a record high
(Figure 5), suggesting credit quality deterioration.
Figure 4. U.S. Leveraged Loan Default Rate
(as of May 21, 2020)
Source: S&P Global.
Notes: LTM = last 12 months. The large spike in early periods was caused by a $20 bil ion single-borrower default of
Energy Future Holdings (TXU).
Figure 5. U.S. Leveraged Loan Downgrades to Upgrades Ratio
(as of April 30, 2020)
Source: S&P Global.
Increased Debt-to-Earnings Leverage
Leveraged loans received their name from borrowers having high debt-to-earnings “leverage,” typically
measured by the debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization) ratio.
The higher the leverage, the lower the companies’ payment capabilities, and the more risk to investors.
link to page 5 link to page 5 link to page 6
Congressional Research Service
5
Leveraged loans’ debt-to-EBITDA ratio has risen substantially since 2019, even before the pandemic,
(Figure 7) largely because of a significant decline in firms’ earnings (Figure 6).
Figure 6. U.S. Leverage Loan Issuer Quarterly EBITDA Growth Rate
(as of March 31, 2020)
Source: S&P Global.
Note: EBITDA = earnings before interest, taxes, depreciation and amortization.
Figure 7. Average Leverage of Outstanding U.S. Leveraged Loans
(as of March 31, 2020)
Source: S&P Global.
Record Covenant Relief Amendments
When borrowers are in trouble, they tend to negotiate with lenders for relief from covenants restricting
their ability to exceed certain limitations. As of April 2020, borrowers and lenders are modifying loan
covenants in record numbers (Figure 8).
link to page 6 link to page 7
Congressional Research Service
6
Figure 8. Number of U.S. Leveraged Loan Covenant-Relief Amendments
(as of May 31, 2020)
Source: S&P Global.
Price Movements
CLOs experienced sharp selloffs in March 2020. Although higher-rated CLOs rebounded to a large extent,
lower-tranche CLOs, which are designed to absorb losses for collateral pools, did not recover at the same
level (Figure 9 and Figure 10).
Figure 9. Price Performance Examples: Funds Invested in Lower-Tranche Collateralized
Loan Obligations
(as of mid-May 2020)
Source: Bloomberg.
Congressional Research Service
7
Figure 10. Leveraged Loan Collateralized Loan Obligation Rebound: Lower-Rated Versus
Higher-Rated
Source: Credit Suisse, Bloomberg.
Federal Government Liquidity Intervention
The Fed—sometimes with support from the Treasury Department—has established
several emergency lending facilities to provide liquidity to key capital markets segments. On
April 9, 2020, the Fed expanded the Term Asset-Backed Securities Loan Facility (TALF) to
provide support for leveraged loan and CLO markets in addition to other asset-backed security
markets. Certain senior tranche AAA-rated static CLOs could qualify under TALF. Static CLOs
are CLOs that do not include a period of reinvestment of collateral proceeds. The eligible CLOs
must be newly issued, on or after March 23, 2020. The Fed expanded TALF again on May 12,
2020, to include CLOs that contain leveraged loans from earlier periods, including those
leveraged loans originated on or after January 1, 2019.
Author Information
Eva Su
Analyst in Financial Economics
Disclaimer
Congressional Research Service
8
This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan shared staff
to congressional committees and Members of Congress. It operates solely at the behest of and under the direction of
Congress. Information in a CRS Report should not be relied upon for purposes other than public understanding of
information that has been provided by CRS to Members of Congress in connection with CRS’s institutional role.
CRS Reports, as a work of the United States Government, are not subject to copyright protection in the United
States. Any CRS Report may be reproduced and distributed in its entirety without permission from CRS. However,
as a CRS Report may include copyrighted images or material from a third party, you may need to obtain the
permission of the copyright holder if you wish to copy or otherwise use copyrighted material.
IN11421 · VERSION 1 · NEW