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Financial Covenants and Fire Sales in Closed-End Funds

Author

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  • Shohini Kundu

    (Anderson School of Management, University of California, Los Angeles, California 90095)

Abstract

Closed-end funds are thought to have negligible fire sale risk as they have stable funding. However, I show that embedded covenants can generate price pressure in collateralized loan obligation (CLO) funds, even though such funds are closed end. Loans held by constrained CLOs report significantly lower cumulative returns than loans held by unconstrained CLOs. This can be explained by contractual arbitrage, a practice by which CLOs exploit loopholes in the design of covenants to mechanically loosen their covenants and avoid covenant breaches. Covenant breaches are associated with significant pecuniary and nonpecuniary costs, affecting CLO compensation, reputation, and career prospects. I show that when covenants breaches are imminent, managers fire sell distressed loans. Hence, I demonstrate a channel by which closed-end funds can also create fire sale risk, akin to their open-end counterparts.

Suggested Citation

  • Shohini Kundu, 2024. "Financial Covenants and Fire Sales in Closed-End Funds," Management Science, INFORMS, vol. 70(2), pages 860-884, February.
    • Handle: RePEc:inm:ormnsc:v:70:y:2024:i:2:p:860-884
    DOI: 10.1287/mnsc.2023.4708
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