Portfolio Dynamics and the Supply of Safe Securities

I study dynamic portfolio rebalancing in Collateralized Loan Obligations (CLOs) by developing an industry equilibrium model of nonbank lending, in which CLOs and loan funds arise endogenously 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.