Collateralized Debt Obligations: Structures and Analysis, Second Edition

CHAPTER 3

High-Yield Loans: Structure and Performance

High-yield corporate loans are an important source of collateral for U.S. collateralized debt obligations (CDOs). In each of the years 2001 through 2005, high-yield loans (also known as leveraged loans) have made up one-fourth to one-third of arbitrage cash flow CDOs. And collateralized loan obligations (CLOs) backed by high-yield loans have out-performed CDOs backed by other forms of corporate debt such as high-yield and investment grade bonds. This is correctly attributed to the superior credit performance of loans and the conservative structure of CLOs. Yet many CDO investors are unfamiliar with high-yield loans.

In this chapter, we attempt to fill that knowledge gap by answering the following questions:

• What exactly is a “loan”?
• How do lenders maintain their senior interest in the borrower's assets?
• How are borrowers prevented from taking actions detrimental to lender's interests?
• What are the trends in loan market size, spreads, and terms?

We also review historical evidence of loan credit quality. Compared to corporate bonds, loans are less likely to default and have higher recoveries if they do default. We think this is because, relative to bond ratings, ratings on loans are more timely and accurate. These factors have led to the excellent credit performance of CLOs.

However, quantitative measures of risk and reward for recently issued loans have been mixed. Over the last two-and-a-half years, borrower leverage has increased ...