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Security design and credit rating risk in the CLO market

Author

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  • Dennis Vink
  • Mike Nawas
  • Vivian van Breemen

Abstract

In this paper, we empirically explore the effect of the complexity of a security's design on hypotheses relating to credit rating shopping and rating catering in the collateralized loan obligation (CLO) market in the period before and after the global financial crisis in 2007. We find that complexity of a CLO's design is an important factor in explaining the likelihood that market participants display behaviors consistent with either rating shopping or rating catering. In the period prior to 2007, we observe for more complex CLOs a higher incidence of dual-rated tranches, which are more likely to have been catered by credit rating agencies to match each other. Conversely, in the period after 2007, for CLOs, it is more likely that issuers shopped for ratings, in particular opting for a single credit rating by Moody's, not by S&P. Furthermore, contrary to what market participants might expect, investors do not value dual ratings more than single ratings in the determination of the offering yield at issuance. Looking at the explanatory power of credit ratings for a dual rated CLO, the degree to which investors increase their reliance on credit ratings depends to a large extent on the disclosure of an S&P rating, not Moody's. This suggests that investors recognize credit rating risk by agency in pricing CLOs. In sum, the policy implication is that, to effectively regulate CLOs, the regulatory environment ought to differentiate between complex and non-complex CLOs.

Suggested Citation

  • Dennis Vink & Mike Nawas & Vivian van Breemen, 2019. "Security design and credit rating risk in the CLO market," DNB Working Papers 643, Netherlands Central Bank, Research Department.
  • Handle: RePEc:dnb:dnbwpp:643
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    References listed on IDEAS

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    Cited by:

    1. Martijn Boermans & Bram van der Kroft, 2020. "Inflated credit ratings, regulatory arbitrage and capital requirements: Do investors strategically allocate bond portfolios?," DNB Working Papers 673, Netherlands Central Bank, Research Department.

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    More about this item

    Keywords

    collateralized loan obligations; credit ratings; security design complexity; rating shopping; rating catering;
    All these keywords.

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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