Intermediary Frictions and the Corporate Credit Cycle: Evidence From CLOs

Abstract: I quantify the contribution of intermediary agency frictions to the cyclicality of lending by non-bank intermediaries. I focus on collateralized loan obligations (CLOs), which are actively managed closed-end funds that provide about one-third of the credit to large speculative-grade corporations in the US and are particularly cyclical in their lending. For variation in agency frictions, I exploit an institutional feature that leads to variation in CLOs’ discretion to trade their assets. I document that CLOs’ cost of debt contains significant compensation for agency problems. Agency problems intensify in bad times when aggregate volatility rises, raising CLOs’ cost of debt, and reducing the issuance of new CLOs. This affects real outcomes of CLO-dependent firms. To mitigate this effect, CLOs issued in volatile periods restrict their discretion in trading, which, however, also reduces their alpha. Calibrating a novel intermediation model to these reduced-form estimates, I find that more than half of the steep fall in CLO issuance during volatile periods is due to agency frictions. A counterfactual analysis reveals that without CLOs restricting their discretion in volatile periods, CLO issuance would be substantially more cyclical and real effects on speculative-grade firms correspondingly larger.