Consequences of CLO portfolio constraints
We examine the effect of portfolio restrictions in Collateralized Loan Obligations (CLOs) on their trading strategy and performance. These restrictions involve tests on loan portfolio characteristics and quality that CLOs have to pass monthly. We find that CLOs with restrictive tests have higher portfolio turnover, rebalancing and diversification, and hold loans for shorter periods, suggesting that managers of constrained CLOs actively administer loan portfolios to alleviate credit losses and costly test violations. We further document that managers of constrained CLOs respond to borrower news differently by trading loans to avoid reporting credit losses and to comply with the CLO tests rather than to generate profits from trading. Last, we examine the economic effects of restrictive portfolio tests and find that these constraints are associated with lower CLO equity returns. Our evidence indicates that portfolio constraints lead to divergent trading choices and to different levels of CLO performance.