June 8 (Bloomberg) -- A “remarkable change” in investor sentiment has doubled the price of some collateralized loan obligation securities in the past month, according to Morgan Stanley analysts.

CLOs are a type of collateralized debt obligation that pool high-yield, high-risk, or junk, loans and slice them into securities of varying risk and return. Pieces graded AA, the third-highest level of investment grade, rose to 47 cents on the dollar from 23 cents in the past month, Morgan Stanley analysts led by Vishwanath Tirupattur wrote in a June 5 report. Securities ranked A have gained 13 cents to 23 cents since the end of last month, the report said.

Ares Management LLC and Boston-based Sankaty Advisors LLC are among investors that started bidding on CLO securities in late April and the first week of May. Prices for portions with A ratings had dropped 90 percent since the financial crisis began in 2007 even as the loans packaged in them had regained some of their value. The S&P/LSTA U.S. Leveraged Loan 100, an index of loans rated below investment grade, rose 12 cents from Dec. 31 to 73.6 cents on the dollar on May 1. Loans have since increased in value to 79 cents.

“The continuing rally in underlying leveraged loans has been a major driver of this change in investor sentiment,” on CLOs, the analysts wrote in the report. A “fierce rally” is under way, they wrote.

Higher Returns

The top-rated CLO bonds have risen to 77 cents on the dollar from 71 cents in May, the report said. High-yield, high- risk loans are rated below Baa3 by Moody’s Investors Service and BBB- by Standard & Poor’s.

Investors bought CLOs because they had higher returns than similarly rated securities. As cash flowed into these funds, they bought almost two-thirds of the funded loans that financed the record $616 billion of leveraged buyouts in the first half of 2007, S&P LCD data show.

The CLO market began to tumble in July 2007 when losses on subprime-mortgage securities caused investors to flee from structured finance. That left banks stuck with more than $230 billion of debt backing buyouts they couldn’t easily sell and led to a collapse in leveraged loan prices to a record low of 59 cents on the dollar in December from above face value, according to the S&P/LSTA index.

Downgrade Pressure

Ares, a Los Angeles-based investment firm with $29 billion in assets under management, sought to buy 22 pieces of CLOs with a face value of as much as $767.6 million on May 6. Boston-based Sankaty, the debt investment arm of Bain Capital LLC, offered to buy as much as $949 million of its own CLOs and those of other managers including Minneapolis-based RiverSource Investments LLC, Eaton Vance Corp. and Deutsche Asset Management Inc. at the end of April.

CLOs are still facing pressure from downgrades of the underlying loans, which are typically used to finance buyouts. The loan funds have limits on assets rated CCC, the eighth- highest junk rating by S&P, and similar ratings by Moody’s. If a portfolio has too many of these assets, it will trip certain tests it needs to meet.

The percentage of assets in CLOs graded CCC “continues to increase,” the analysts wrote. More than half of U.S. CLOs are failing the junior over-collateralization test, they said.

The rally in the securities may be close to over as rating companies downgrade the CLO debt, the analysts wrote.

“We are more comfortable with the rally in the AAA tranches than we are with the exuberance lower down the capital structure,” the analysts wrote.

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

Last Updated: June 8, 2009 16:18 EDT