Security Design and Credit Rating Risk in the CLO Market

Posted: 19 Jul 2019

See all articles by Dennis Vink

Dennis Vink

Nyenrode Business University

Mike Nawas

Nyenrode Business University

Vivian van Breemen

De Nederlandsche Bank

Date Written: July 16, 2019

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.

Keywords: collateralized loan obligations, credit ratings, security design complexity, rating shopping, rating catering

JEL Classification: G14, G24, G28, G32

Suggested Citation

Vink, Dennis and Nawas, Mike and van Breemen, Vivian, Security Design and Credit Rating Risk in the CLO Market (July 16, 2019). De Nederlandsche Bank Working Paper No. 643, Available at SSRN: https://ssrn.com/abstract=3422118 or http://dx.doi.org/10.2139/ssrn.3422118

Dennis Vink (Contact Author)

Nyenrode Business University ( email )

Straatweg 25
P.O. Box 130
Breukelen, 3620 AC
Netherlands

HOME PAGE: http://www.dennisvink.nl

Mike Nawas

Nyenrode Business University ( email )

Straatweg 25
P.O. Box 130
Breukelen, 3620 AC
Netherlands

Vivian Van Breemen

De Nederlandsche Bank ( email )

PO Box 98
1000 AB Amsterdam
Amsterdam, 1000 AB
Netherlands

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