Corporate Loan Securitization and the Standardization of Financial Covenants

• DOI: http://doi.org/10.1111/1475-679X.12186
• Published date: 01 March 2018
• Date: 01 March 2018

DOI: 10.1111/1475-679X.12186

Journal of Accounting Research

Vol. 56 No. 1 March 2018

Printed in U.S.A.

Corporate Loan Securitization and

the Standardization of Financial

Covenants

ZAHN BOZANIC,

∗MARIA LOUMIOTI,

†

AND FLORIN P. VASVARI

‡

Received 25 January 2015; accepted 23 August 2017

ABSTRACT

We examine whether syndicated loans securitized through collateralized loan

obligations (CLOs) have more standardized financial covenants. We proxy

for the standardization of covenants using the textual similarity of their con-

tractual definitions. We find that securitized loans are associated with higher

covenant standardization than nonsecuritized institutional loans. In addition,

∗The Ohio State University; †University of Texasat Dallas; ‡London Business School.

Accepted by Douglas Skinner. We would like to thank an anonymous referee, Peter De-

merjian (discussant), Brad Badertscher, Anne Beatty, Thomas Gilliam, Gerard Hoberg, Alon

Kalay, Venky Nagar, Doron Nissim, Panos Patatoukas, Jennifer Stevens, K.R. Subramanyam,

Joe Weber, Regina Wittenberg-Moerman, and workshop participants at Babes-Bolyai Uni-

versity, the University of Exeter, Columbia University, Instituto de Empresa, London Busi-

ness School, the Stockholm School of Economics, the University of Notre Dame, the 2015

AAA Financial Accounting Reporting Section meeting, the University of Michigan, the Uni-

versity of Southern California, and the University of Oulu for their helpful comments and

suggestions. We are also grateful to Colin Atkins (Managing Director and Head of the

European Structured Credit at the Carlyle Group), John Markland (Founding Partner of

the European Debt Finance Team at Kirkland & Ellis), Gauthier Reymondier (Managing

Director at Sankaty Advisors), as well as two other senior professionals who chose to re-

main anonymous. We thank Blake Sainz for his excellent research assistance. Bozanic ac-

knowledges financial support from the Fisher College of Business. Loumioti acknowledges

financial support from the University of Texas at Dallas and MIT Sloan School of Man-

agement. Vasvari acknowledges financial support from the London Business School RAMD

fund. All errors are our own. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

45

Copyright C, University of Chicago on behalf of the Accounting Research Center,2017

46 Z.BOZANIC,M.LOUMIOTI,AND F.P.VASVARI

we show that CLOs with more diverse or frequently rebalanced portfolios are

more likely to purchase loans with standardized covenants, potentially be-

cause standardization alleviates information processing costs related to loan

monitoring and screening. We also document that covenant standardization

is associated with greater loan and CLO note rating agreement between

credit rating agencies, further supporting the relation between lower infor-

mation costs and covenant standardization. Overall, our study provides evi-

dence that loan securitization is related to the design of standardized finan-

cial covenants.

JEL codes: G17; G21; G32; M40; M41

Keywords: securitization; standardization; collateralized loan obligations

(CLO); financial covenants; syndicated loans

1. Introduction

The role of borrower-specific financial covenants in monitoring credit

risk has been well established in the accounting literature (e.g., Dichev

and Skinner [2002], Christensen, Nikolaev, and Wittenberg-Moerman

[2016]). Prior studies show that lenders adjust the accounting definitions

in covenants to alleviate agency costs and acquire timely signals of a bor-

rower’s financial performance (e.g., Leftwich [1983], Beatty, Ramesh, and

Weber [2002], Li [2010], Dyreng, Vashishtha, and Weber [2017]). How-

ever, the extent to which the customization of covenant specifications varies

across different types of lenders has received little attention in the litera-

ture. We investigate whether syndicated loans securitized through collater-

alized loan obligations (CLOs) have more homogenous and comparable

(standardized, hereafter) financial covenants.

CLOs are special purpose entities that purchase high-yield syndicated

loans and use the principal and interest payments of these loans to is-

sue new notes.1Over the past 15 years, CLOs have become the domi-

nant institutional investor in syndicated loans, reaching a 70% share in the

high-yield loan market with an annual issuance of CLO notes that exceeds

$100 billion (Standard and Poor’s Leveraged Commentary & Data [2014]).

Certain characteristics inherent to CLOs make these entities different from

other nonbank loan investors. CLOs invest in large and well-diversified loan

portfolios to shield their performance from idiosyncratic credit risks (Jobst

[2002], Ayotte and Bolton [2011]). For instance, the average CLO invests

in about 200 loans that are issued by different borrowers in various indus-

tries and rebalances the loan portfolio on a monthly basis to improve its

1High-yield loans are issued to highly leveraged companies and are usually rated nonin-

vestment grade. Banks typically invest in 10–15% of a high-yield syndicated loan with the re-

maining amount being purchased by nonbank institutional investors such as CLOs and hedge

funds (Standard and Poor’s Leveraged Commentary & Data [2015]).

LOAN SECURITIZATION AND STANDARDIZED FINANCIAL COVENANTS 47

performance.2These characteristics suggest that, while CLOs might engage

in less screening and monitoring on a per loan basis, they likely face greater

total portfolio screening and monitoring costs than other institutional in-

vestors.

While CLOs can rely on a variety of mechanisms to lower screening and

monitoring costs, we anticipate that the structure of loan covenant speci-

fications is likely to provide one such mechanism. We hypothesize that se-

curitized loans have more standardized financial covenants because, rela-

tive to customized borrower-specific covenants, such covenants are likely to

help CLOs screen and monitor their portfolios in a more efficient way. Al-

though standardized covenants do not provide the precise default signals

that customized covenants do, we argue that CLOs are willing to trade off

this precision to balance their high information costs associated with the

monitoring and screening of their loan portfolio.

First, as CLO portfolios include marginal loan investments covering a

highly diversified set of borrowers and industries, portfolio performance

exposure to borrower-specific credit risk is limited. Thus, collecting and

processing information on customized covenants to assess loan quality is

potentially more costly relative to the benefits of receiving precise default

signals. Standardized covenants can help CLOs to alleviate the high infor-

mation costs from portfolio diversification while still providing a default

signal that supports monitoring activities. Second, as CLOs rebalance their

portfolios on a monthly basis, investing in loans with customized covenants

can increase CLO portfolio screening costs. Financial covenants with more

standardized definitions require less data collection, which likely lowers

information costs and thus overall transaction costs. Third, customized fi-

nancial covenants can lead to more disagreements between the credit rat-

ing agencies that rate CLO loans and notes (e.g., Jobst [2002], Ayotte and

Bolton [2011]). Greater rating disagreements increase CLOs’ information

costs, whereas standardized financial covenants with more similar specifica-

tions likely facilitate more comparable credit rating assessments.3

We test our hypothesis using a sample of 3,303 complete financial

covenant definitions in 440 securitized and 703 nonsecuritized high-yield

loan contracts issued over the 2000–2009 period. We obtain data on loan

securitizations from CLO-i, a global platform that collects detailed infor-

mation on CLO loan portfolios, and data on high-yield institutional loans

from LPC DealScan. We match these databases with firms’ Securities and

2The statistics on CLO portfolio size are derived from the CLO-i securitized portfolio

database, which we also use in this study. To provide a comparison, based on the LSTA Trade

Data Study [2014], institutional loans were traded in the secondary market about 15 times per

quarter in 2013, while the average securitized loan in the CLO-i loan trade database traded

roughly 40 times per quarter in the same year.

3However, it is possible that CLOs do not heavily rely on covenants to monitor and screen

their loan portfolios given that other CLO characteristics (e.g., reliance on credit ratings,

diversification) and features of securitized loans might drive covenant standardization.