Over the last few years, the corporate loan market has experienced significant growth. Arguably, the most significant development has been the securitization of syndicated loans through Collateralized Loan Obligations (CLOs). CLOs are special purpose entities that purchase high-yield corporate loans and use the principal and interest payments of these loans as collateral to issue new senior and junior notes (called CLO notes) that are bought by banks and non-bank institutional investors such as hedge funds and insurance firms. The CLO loans and notes are rated by at least two credit rating agencies to reduce information asymmetry between managers and investors. According to a report by Standard and Poor’s , CLOs have become the dominant institutional investor in syndicated loans, reaching a 70 percent share in the high-yield loan market with an annual issuance of CLO notes that exceeds $100 billion.
Certain characteristics inherent in CLOs make these investors different from other non-bank lenders. CLOs invest in large and well-diversified loan portfolios to shield their performance from idiosyncratic credit risks. The average CLO size is $500-$600 million, which is invested in about 200 loans issued by different borrowers in various industries. CLOs rebalance their loan portfolio on a monthly basis to improve their performance. More specifically, during the two-year period after their origination, CLOs sell about 30 percent of their initial loan investments and repurchase other loans. This significant trading activity suggests that CLOs likely face greater total portfolio screening and monitoring costs relative to other institutional investors.
In a new paper, we examine whether loan securitization increased the demand for more standardized financial covenant structures. We focus on financial covenant specifications since this section of the loan contract contains less boilerplate and is typically customized to reflect borrower-specific idiosyncrasies. We argue that securitized loans have more standardized financial covenants because, relative to customized borrower-specific covenants, such covenants are likely to help CLOs screen and monitor their portfolios more efficiently. Although standardized covenants do not provide the precise default signals that customized covenants do, we posit that CLOs are willing to trade off this precision to balance the high information costs associated with the monitoring and screening of their loan portfolios.
Several arguments support our prediction. First, as CLO portfolios include marginal loan investments covering a highly diversified set of borrowers and industries, the exposure to borrower-specific credit risks is limited. Collecting and processing information on customized covenants to assess loan quality is potentially more costly than the benefits of receiving precise default signals. Standardized covenants can help CLOs alleviate the high information costs from portfolio diversification while still providing a default signal that supports monitoring activities. Second, as CLOs rebalance their portfolios on a monthly basis, investing in loans with customized covenants can increase CLO portfolio screening costs. This occurs because customized covenants involve more extensive borrower-specific data collection and analysis when CLOs purchase loans, which adversely affects the timeliness or even the execution of these trades. In contrast, financial covenants with more standardized definitions require less data collection, which likely reduces screening and information processing costs related to CLO trades. Third, customized financial covenants can lead to more disagreements between the credit rating agencies that rate CLO loans and notes. More rating disagreements increase information asymmetry with respect to securitized loan quality, resulting in higher CLO portfolio monitoring and screening costs. Standardized financial covenants with more similar specifications likely facilitate more comparable credit rating assessments.
Using a hand-collected sample of 3,303 complete financial covenant definitions in 440 securitized and 703 non-securitized high-yield loan contracts issued from 2000-2009, we develop a proxy for the standardization of financial covenants by measuring the textual similarity of their contractual definitions.
We find that securitized loans are associated with more standardized financial covenants relative to other institutional loans. In terms of economic magnitude, relative to non-securitized institutional loans, securitized loans have a covenant similarity score that is higher by about 20 percent of the variable’s sample standard deviation. We document that covenant standardization increases (decreases) with the extent of CLOs’ (banks’) loan ownership, and that loans securitized at the time of origination (i.e., when CLOs are members of the primary loan syndicate) have greater covenant similarity than loans securitized later (i.e., when CLOs buy these loans in the secondary market).
We further examine the CLO characteristics associated with the covenant standardization of securitized loans. We show that CLOs with more diversified loan portfolios are more likely to invest in loans with standardized covenants. These loans are likely to help alleviate the high information collection and processing costs of diversified CLOs. Moreover, we document that CLOs that significantly rebalance their portfolios are more likely to invest in loans with greater covenant standardization, potentially because standardization contributes to lowering these CLO’s high screening costs. Lastly, we find that standardization is related to greater agreement between S&P and Moody’s credit ratings on CLO loans and notes. This evidence suggests that covenant standardization can facilitate more comparable credit risk assessments, further supporting the lower information costs of standardized covenants.
The findings of our paper shed new light on how financial contracts – and, in particular their financial covenant terms – vary across different lender types. In contrast to prior research on customized covenants, CLO lenders facing higher information and screening costs are likely to demand more standardized covenant specifications to alleviate such costs. We further extend studies documenting a positive association between CLO fund flows and the issuance of loans with no financial covenants (i.e., “covenant-lite” loans). We add to these studies by showing that covenant-lite lending might simply reflect an extreme form of covenant standardization that is an inherent characteristic of securitized loans.
This post comes to us from Professor Zahn Bozanic at Ohio State University’s Fisher College of Business, Professor Maria Loumioti at the University of Texas at Dallas, and Professor Florin P. Vasvari at London Business School. It is based on their recent paper, “Corporate Loan Securitization and the Standardization of Financial Covenants,” available here.