Nov. 4 (Bloomberg) -- Leveraged loans will outperform high- yield bonds because the collapse in prices for the debt has been overdone, according to Neil McLeish, a strategist at Morgan Stanley.

``Leveraged loans have shown attractive risk-adjusted performance versus other fixed-income assets, especially high- yield bonds,'' London-based McLeish wrote in a note to clients today. Panic selling triggered by some funds forced to unwind loan portfolios is ``largely overdone,'' he wrote.

The average bid for European leveraged loans fell as low as 71.62 percent of face value on Oct. 23, according to Standard & Poor's LCD. The price of loans tumbled on investor concern that banks and hedge funds had to sell assets in the wake of the collapse of Iceland's banks and Lehman Brothers Holdings Inc. in New York. Falling values forced funds to sell a record $2.3 billion in the first three weeks of October, S&P data show.

Loans rank above bonds for repayment in a bankruptcy and have in the past recovered more in a default than high-yield securities, McLeish wrote. Lenders have recouped between 55 and 90 percent, compared with 20 to 60 percent for holders of bonds to speculative-grade companies.

``Buying loans today is effectively purchasing an option to buy corporate cash flows at relatively cheap multiples,'' according to the report. The debt should beat bonds ``given a slowing economic environment.''

Returns from leveraged loans are down 20 percent in the U.S. and Europe this year, compared with a drop of more than 30 percent in high-yield bonds, McLeish wrote. European loans lost five percent in 2007 after returning about five percent in the previous three years.

Hedge Fund Unwinds

Leveraged loans are rated below Baa3 by Moody's Investors Service and BBB- by S&P.

McLeish said only a ``small proportion'' of collateralized loan obligations, which package debt into securities of varying ratings and returns, are sensitive to price swings. So-called market-value CLOs have to sell assets to repay bondholders if certain price triggers are breached.

Hedge fund unwinds and bank sales remain a threat to the loan market, though ``this is somewhat offset by the improved capital position of many large U.S. and European banks, and the greater resilience of much of the CLO investor base,'' McLeish wrote.

To contact the reporter on this story: Caroline Hyde in London chyde3@bloomberg.net.

Last Updated: November 4, 2008 13:32 EST