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Europe CLO Equity Offers Attractive Investments, Citigroup Says

The riskiest portion of European collateralized loan obligations can offer an attractive investment amid record-low yields for other types of debt, Citigroup analysts said.

CVC Credit Partners, GoldenTree Asset Management LP, Oak Hill Advisors LP, Cairn Capital Ltd., Ares Capital Corp., Sankaty Advisors LLC and Societe Generale SA’s Egret Capital LLP generated quarterly payments of more than 6 percent from their investments in the so-called equity portions of European CLOs, compared with an industry average for Europe of 3 percent to 4 percent, according to a Citigroup research report of Nov. 6.

CLOs are a type of collateralized debt obligation that pool high-yield, high-risk debt and slice them into securities of varying risk and return. The equity portion is the lowest-ranking part of the structure.

“As investors look for yield opportunities, European CLO equity should be on the shopping list,” analysts led by New York-based Ratul Roy wrote in the report. “The European landscape is riddled with uncertainty. Yet our study has shown that deals have outperformed, and some managers have visibly out-distanced the pack.”

The average yield for speculative-grade bonds fell to a record low of 6.6 percent on Oct. 18 while monthly returns slid to 1.2 percent from 3.7 percent in January this year, according to Bank of America Merrill Lynch’s Global High Yield Constrained Index.

Alpha Returns

U.S. CLO equity generated returns of 40 percent this year, according to Citigroup, compared with 12 percent for Standard & Poor’s 500 Index.

“It’s good that investors are now distinguishing between managers on performance and their ability to generate alpha, rather than size and perceived access to primary flow,” Andrew Burke, Cairn Capital’s London-based head of loan business, said in an e-mail. So-called alpha measures fund managers’ ability to generate returns above market benchmarks.

Borrowers have repaid defaulted senior-ranking European leveraged loans at higher rates than expected helping to support returns for CLO investors, the Citigroup analysts said.

Investors recovered an average of 76 percent of face value from first-claim secured debt based on 101 defaults in Europe between 2003 and 2010, compared with 84 percent for U.S. loans between 1987 and 2011, according to a Standard & Poor’s report on April 30.

Investors should be wary of CLOs with large portions of distressed loans, those trading at below 80 cents on the euro, as these can provide poor cash flows to investors in the equity slices, the Citigroup analysts said.

Steve Tananbaum, chief investment officer at GoldenTree, the media relations department of Oak Hill and Carl Drake, head of capital markets and investor relations at New York-based Ares, didn’t reply to phone calls and e-mails. A spokesman in London for Sankaty declined to comment. Societe Generale spokesman Murray Parker could not be reached for comment. Jane Howard, an investor relations manager for CVC, couldn’t immediately comment.

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