Investors in collateralized loan obligations (CLOs) – or pools of debt and debt-securities - may be inadvertently be exposing themselves to risks by failing to realize that the same corporate credits can reappear repeatedly in these CLOs, Standard and Poors, the rating agency has warned.

This so-called “overlap” problem could make investors more vulnerable to specific corporate defaults than they had realized – particularly since some investors have purchased debt portfolios with more leverage in an effort to boost their returns.

“Current conditions in the US loan market are forcing CLO managers to invest repeatedly in the same names,” the report from the credit rating agency notes. “As a result, the question arises as to whether portfolio managers and CLO investors are obtaining enough diversity.”

S&P points out that investors can mitigate this problem by effectively screening their CLOs in detail to understand such overlaps. And some banks are currently scrambling to offer products which do just this, to ease investor concern. “This is not a problem for anyone who properly understands what is in the [CLO],” says one banker.

However, the S&P report casts the spotlight on the speed at which this market is growing at a time when some policy makers are questioning whether all the end investors fully understand the implications of these instruments – particularly if the credit cycle turns.

The collateralised debt obligation (CDO) market – of which CLOs are a subset – was believed to total $360bn last year, twice its level at the start of the decade, according to JP Morgan. Meanwhile, global issuance of CLOs has been four times higher this year than the comparable period last year.

Investors such as life assurance companies have scrambled to buy CDOs in recent years since these instruments offer to help investors manage risk via diversification and customization. The typical CDO will contain numerous credits, and investors have a choice of purchasing different tranches of the portfolio, with differing levels of risk.

However, more recently, many investors have also started investing in highly leveraged instruments. This growing complexity, coupled with a shortage of suitable debt instruments due to the benign credit cycle, means that the same corporate names can frequently reappear in a CDO.

S&P, for example, surveyed 15 managers who run some 67 US CLOs and found that about half the corporate names in any single CLO cropped up in another CLO.

Reassuringly, the most sophisticated asset managers who run these instruments appear to be relatively aware of the overlap risk, S&P said. However, it remains unclear whether that awareness is matched by the end investors. And while less research has been done in Europe, the pattern there is believed to be similar to that of the US.

Get alerts on Capital markets when a new story is published

Copyright The Financial Times Limited 2019. All rights reserved.
Reuse this content (opens in new window)

Comments have not been enabled for this article.

Follow the topics in this article