Nov. 6 (Bloomberg) -- KKR Financial Holdings LLC, the unit of KKR & Co. that lost $1.1 billion in 2008, made $67.2 million last quarter, underscoring a recovery for the debt investments that contributed to the worst credit crisis since the 1930s.

The division, which was started in 2004 and now manages $8.5 billion of corporate debt, said yesterday it more than tripled its net income from the second quarter as high-yield, high-risk loan prices gained 10.5 percent in the period.

KKR is emblematic of a turnaround for firms that manage collateralized loan obligations, such as Highland Capital Management LP and Aladdin Capital Holdings LLC, as the $440 billion CLO market rallies on speculation that company defaults will slow as the economy emerges from the recession that began in December 2007.

“CLOs that were written off earlier this year in terms of fees paid to the manager are being turned backed on again,” said Neal Neilinger, chief investment officer of Aladdin. The Stamford, Connecticut-based firm has $3.5 billion of CLOs and $12.5 billion in assets under management.

The lowest-rated pieces of CLOs, which pool high-yield, high-risk loans and slice them into securities of varying risk, have climbed to 30 cents to 40 cents on the dollar from less than 10 cents seven months ago, according to a Nov. 4 report from Morgan Stanley. Those ranked BBB have risen to 59 cents from 6 cents on the dollar in the past six months.

San Francisco-based KKR Financial has increased more than 12-fold to $5.18 as of yesterday, since reaching a low in March of 42 cents. Shares tumbled 89 percent in 2008.

‘Improved Market Conditions’

“During the past nine months, we have significantly improved our situation as a result of improved market conditions and some pro-active actions,” KKR Financial Chief Executive Officer William Sonneborn said yesterday during a conference call with investors.

CLOs, a form of collateralized debt obligation that invest in leveraged loans, were popular before the credit markets seized up in late 2007 because they offered investors higher yields than similarly rated securities. The $58 million AA ranked portion of KKR Financial CLO Ltd. sold in March 2005 paid interest at 45 basis points more than benchmark bank rates. That compared with a spread of as little as 36 basis points for companies of the same grade, according to Merrill Lynch & Co. indexes. A basis point is 0.01 percentage point.

High-yield, high-risk debt is rated below BBB- by Standard & Poor’s and less than Baa3 at Moody’s Investors Service. Leveraged loans are repaid first in bankruptcy, ahead of bonds and equities.

The default rate for high-yield companies may peak at 12.5 percent next month, before declining “sharply” to 4.2 percent by October 2010, Moody’s said yesterday in a report.

Lehman Collapse

Loan prices tumbled an average of 28 percent in 2008, a record according to the S&P/LSTA U.S. Leveraged Loan 100 Index, as Lehman Brothers Holdings Inc.’s collapse caused investors to flee all but the safest government debt.

Highland, the Dallas-based investment firm, said in October 2008 that it was liquidating its main hedge fund following “unprecedented market volatility and disruption.”

While prices dropped to as low as 59.2 cents on the dollar in December, loans have returned 45 percent this year. The lowest-ranked loans have rallied 80 percent, S&P LCD data show.

Collateralization Tests

CLOs can typically hold no more than 7.5 percent of assets rated below CCC+ by S&P. Once that threshold is breached, funds have to value their assets at market prices. Of 482 CLOs tracked by New York-based Morgan Stanley, the number of deals failing so-called junior over-collateralization tests has fallen to 219 from 247 last month, according to the report.

Violating these rules may force managers to stop payments on the lowest-rated portions of a CLO and divert cash to repay the higher-rated pieces. Four of KKR’s CLOs holding about $7 billion of loans were breaching tests earlier this year, according to a March 2 regulatory filing by the firm.

More than 12 percent of deals that were breaking so-called junior overcollateralization tests as recently as June are now passing, “which means their subordinate fees are back in the money,” Gene Phillips, a director at PF2 Securities Evaluations Inc., an advisory firm said in a telephone interview.

The safest portions of CLOs have climbed 18 cents to 89 cents on the dollar in the past six months, Morgan Stanley data show.

“We’re approaching a turning point for some CLO managers,” Vishwanath Tirupattur, a debt analyst at Morgan Stanley in New York, said in a telephone interview. “The increase in CCC prices has had a huge impact on the CLOs. We’re living in a different world compared to March.”

Kevin Latimer, a partner at Highland, which has 28 CLOs comprising $18.6 billion in assets, declined to comment yesterday.

The improvement is encouraging new corporate debt issuance, Neilinger said. “You’re seeing the first signs of banks underwriting multi-billion dollar bank deals.”

To contact the reporter on this story: Pierre Paulden in New York at ppaulden@bloomberg.net

Last Updated: November 6, 2009 00:00 EST