Portfolio Dynamics and the Supply of Safe Securities
Publication Date
4-1-2025
Abstract
This paper studies the use of dynamic portfolios as collateral in Collateralized Loan Obligations (CLOs). I develop an industry equilibrium model of nonbank lending in which CLOs and loan funds endogenously arise in response to a premium for safe securities. When loans deteriorate after issuance, CLOs rebalance their portfolios to maintain collateral quality, which protects senior tranches at the expense of equity investors. This "self-healing" mechanism lowers CLOs' ex-ante funding costs by enabling the issuance of larger safe tranches. As more lenders operate CLOs, their portfolio rebalancing generates greater non-fundamental price pressures, incentivizing other lenders to operate loan funds. Overall, portfolio dynamics facilitate risk sharing across nonbank lenders and increase both total lending and the supply of safe securities relative to static portfolios.
Document Type
Article
Disciplines
Finance
DOI
10.2139/ssrn.5212536
Source
SMU Cox: Finance (Topic)
Language
English
