Least Risky Slice of CLOs Most Compelling, Wells Fargo Says

The least risky portion of collateralized loan obligations offers investors the most compelling yield relative to risk, according to Wells Fargo & Co.

While coupons on the AAA portion of CLOs are now “testing” the area of 140 basis points more than the London interbank offered rate, they generally haven’t tightened as much as lower-rated pieces of the funds, the San Francisco-based bank said yesterday in a research report.

CLOs, which buy high-yield loans and slice them into securities of varying risk and return, have pooled more than $40 billion of this year, more than tripling the $12.9 billion raised in 2011, according to the report.

“AAA spreads, especially new issue AAA spreads, are by far the most compelling in the stack” from a risk-reward standpoint, Dave Preston, a Charlotte, North Carolina-based analyst for Wells Fargo, wrote in the report.

Earlier this month, Jefferies Group Inc. raised a $406.5 million CLO for Alcentra including a slice rated AAA that offers a coupon of 141 basis points more than Libor, according to data compiled by Bloomberg. A basis point is 0.01 percentage point.

“For investors that require more yield than the AAA spreads provide, we still favor primary mezzanine notes as the best value,” Preston wrote.

The loan market has become more “issuer-friendly” with the cost of bank debt falling since July, even as companies increased leverage this year, Wells Fargo said. More than 60 percent of new loans this year have been used for refinancing or to pay shareholder dividends, according to the report.

“Higher leverage and tighter spreads are not generally optimal for CLO investors,” Preston wrote.

A rise in corporate borrowing costs in October is positive for CLO investors as it may be a sign of “increased discipline” on the part of lenders, he wrote in the report.

To contact the reporter on this story: Christine Idzelis in New York at cidzelis@bloomberg.net

To contact the editor responsible for this story: Faris Khan at fkhan33@bloomberg.net

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