Take Junk Loans, Add Leverage, Slice ’Em Up, Sell, Repeat

Here’s a brain twister: Some investors have grown tired of junk-rated loans, but others are more eager than ever to buy the same debt bundled together and sliced into pieces.

Buyers are particularly hungry for the riskiest tiers of these collateralized loan obligations, investments that are the first to lose out if borrowers fail to make interest and principal payments. They also stand to reap bigger returns when companies pay back their loans.

Principals at the private-equity firm Stone Point Capital LLC are seeking to capitalize on this boom in demand by starting a new closed-end firm focused mainly on buying the lowest-ranked tranches of CLOs. The proposed Eagle Point Credit Co. can use borrowed money to juice returns on speculative-grade securities backed by junk-rated loans, according to a June 6 filing with the U.S. Securities and Exchange Commission.

“Even though demand has waned for leveraged loans, the same cannot be said for CLOs,” Barclays Plc strategists Bradley Rogoff and Eric Gross wrote in a June 6 report.

Investors in the riskiest slices of these loan securitizations are accepting lower returns, helping boost CLO sales to a record pace of $46 billion this year through May 31, according to the analysts. JPMorgan Chase & Co. strategists predict CLO sales may reach an unprecedented $100 billion this year. Those figures are indicative of the race to buy riskier assets that’s permeating almost every corner of the global debt markets.

Loan Outflows

At the same time, investors yanked $1.1 billion from loan mutual funds in the week ended June 4, the biggest withdrawal since August 2011 and the eighth consecutive week of outflows, according to Wells Fargo & Co. data.

The dichotomy is in part a big buyer versus little buyer phenomenon. Bigger institutions like the debt, which is pegged to floating-rate benchmarks and typically gets repaid before bonds in bankruptcies, even as individuals lose interest.

There’s a technical element to it too. As long as benchmark rates remain low, the structure of CLOs allows investors in the riskiest portions to pocket excess yield paid by the underlying loans relative to the rates collected by more senior noteholders.

CDO Collapse

The unprecedented stimulus by the Federal Reserve and other central banks around the world is pushing bond yields to record lows. As a result, investors are more concerned about missing out on returns than about the prospect of losing money when companies default, especially since it’s about the easiest ever for them to borrow more cash at low rates.

There’s evidence to give buyers such conviction: Moody’s Investors Service has predicted the global speculative-grade default rate will decline to 2.1 percent at year-end from 2.3 percent in May. By comparison, the default rate in the U.S. exceeded 11 percent after the financial crisis took its toll in late 2009, according to Standard & Poor’s data at the time.

While that crisis fueled the demise of collateralized debt obligations, which largely packaged mortgage-related debt and derivatives, CLOs survived. They didn’t suffer the same losses that wiped out CDOs when housing values plunged. Instead, they thrived as the Fed’s unprecedented efforts to lower borrowing costs and shore up the economy bolstered corporate balance sheets.

The Eagle Point company will be managed by a team led by Thomas Majewski, former U.S. head of CLOs at RBS Securities Inc., and plans to raise money through an offering led by Deutsche Bank AG and Keefe Bruyette & Woods, according to the filing. Its investment adviser, Eagle Point Credit Management, had $391 million of committed assets under management as of March 31 after being established in 2012 by Majewski and Stone Point.

If the first five and half months of 2014 are an indication of demand, there may be plenty of it for this deal.

It’s a sign of the times in a zero-rate world.

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