It has been 10 years since the financial crisis and many pundits are using this arbitrary anniversary to prognosticate the next great financial calamity. Collateralized loan obligations (CLOs) have taken their turn in the spotlight, cast as the villain most likely to bring the global economic system to its knees.

Make no mistake, risk is elevated—particularly for the broader corporate credit arena. Central banks responded to the global financial crisis by providing unprecedented amounts of liquidity, which fueled debt market growth and investor risk taking. Recent credit expansion has been in non-traditional categories, including senior loans, the underlying collateral of CLOs. However, gaining a comprehensive view of risk in this environment requires a deep understanding of the different instruments used to gain corporate credit exposure. As headlines and fear mongering reverberate around doomsday scenarios caused by CLOs, panic is not the proper course of action. Why? Because we think the following insights can help efficiently navigate the path ahead.

Proven Track Record: CLOs Tested ‘Through-The-Cycle’ Performance

It is important to understand that CLOs are not some new flashy product; they have been around since the late 1980s.

Since inception, AAA- and AA-rated CLO tranches never experienced a default or loss of principal, even during the depths of the financial crisis. Lower-rated tranches of CLOs have only experienced minimal long-term impairment rates over this same time period, faring much better than other corporate credit sectors of the same credit quality.

Collateral: CLOs Provide Exposure To A Senior-Secured Asset Class

Senior loans, the underlying collateral of CLOs, are a large part of the reason why CLOs have delivered a track record of low impairment rates. Senior loans hold the highest rank in a borrower’s capital structure, making them less risky. In the event of a borrower’s bankruptcy, or other liquidation scenario, senior loan obligations would be paid first, ahead of loans or liabilities. Furthermore, senior loans contain contractual provisions, or covenants, that impose limits on what the borrower may do with the borrowed money.

It is important for investors to remember that despite the senior secured status of loans, the asset class still represents lending to companies that are below investment grade. Like other below investment grade allocations, nothing is guaranteed and issuer selection based on rigorous fundamental research is critical, especially in the latter stages of a credit cycle. For example, attention to detail in covenant packages is of particular importance in today’s lending environment.

Covenant packages, when measured overall in the asset class, have deteriorated in terms of their quality in recent years. While the implications are uneven across issuers, this is an enhanced risk for investors to chart course around when investing in CLOs.

In addition to the senior-secured status of their underlying collateral, CLOs have embedded structural protections provided by a cash diversion mechanism of the CLOs. This mechanism is governed by overcollateralization (OC) and interest coverage (IC) tests, and is triggered if there is meaningful deterioration in collateral performance from levels set at inception of the CLO.

Conceptually, overcollateralization tests require that the amount of senior secured loans held in the underlying collateral pool of a CLO has to exceed the amount promised to investors who purchase the debt tranches of the CLO by a certain percentage. Why does this matter? The levels of excess collateral in current CLOs would allow them to withstand the default and recovery experience of past credit cycles. For additional perspective, stress tests of a recent CLO showed that generating a principal loss in the BB tranche would require a constant default rate of 4.44 percent (assuming a 40 percent recovery rate) over the span of 8.5 years.

If any overcollateralization or interest coverage tests fail, the CLO diverts interest and principal due to junior tranches to pay down senior tranches (or, purchase more collateral in certain cases) until such time that the covenants are back in compliance. These protections improve the resiliency of the more senior CLO debt tranches to default experience.

Revised Rating Agency Methodologies And Enhanced Regulatory Environment

Despite its strong history, the asset class wasn’t immune from the sweeping regulatory changes and rating agency methodology revisions following the wake of 2008. This means the CLO market has become stronger from these important dimensions.

New U.S. regulations imposed after the financial crisis reduced reliance on leveraged investors in the CLO market and influenced an improved risk profile via Volker Rule provisions. Real money investors such as pension funds, asset managers and insurance companies, especially those from Asia, are larger holders of the asset class. Stable long-term investors represent a significant portion of CLO market participants.

This Risk In CLOs is Idiosyncratic, NOT Systemic

Despite improved regulatory framework, and the sector’s proven track record, CLOs aren’t for everybody. CLOs are compelling for buy and hold investors like insurance companies that have emerged as a significant presence in the CLO market. In addition, for multi-sector fixed income strategies with the appropriate structural and credit expertise, CLOs can diversify a broader fixed income portfolio. However, in the context of multi-sector portfolios, CLOs can experience periods of pricing volatility in secondary markets. We witnessed this in December 2018 and CLOs have been slower to retrace spread widening relative to other risk markets.

It is also important for investors to understand that risk across the asset class isn’t uniform—bad actors do exist and, like in any market, so does risk and so does reward. That said, as an asset class, we view the risk in CLOs as idiosyncratic and believe the systemic, fear mongering doomsday scenarios are ultimately exaggerated.

Dave Goodson is head of securitized at Voya Investment Management. Mohamed Basma, CFA, is senior vice president and portfolio manager at Voya Investment Management.