Rising interest rates could reduce an important form of credit enhancement for U.S. collateralized loan obligations, potential putting them at risk for downgrades in their credit ratings, according to Moody’s Investors Service.

In its October CLO Interest report, Moody’s said that increases in short-term rates, widely expected to take place next year, would be a “credit negative” event for U.S.-based CLOs because of the resulting reduction in credit enhancement called excess spread. This is the difference between the interest rate on the notes issued by CLOs and the interest rates on the loans that they acquire. Interest rates on both their liabilities and assets are expressed as a spread over the London Interbank Offered Rate, or Libor.

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