Leveraged loans to companies are likely to be adversely affected by hedge fund losses from collateralized debt obligations (CDOs). This indirect effect of the subprime mortgage problem would hit corporations despite their current exceptionally low default rate and overall strong growth potential.

Mortgage-backed CDO notes are distinct from notes issued on structured pools of company loans, or collateralized loan obligations, but there are common grounds. Since hedge funds buy both types of structured notes, if they are burned by one, they will probably be reluctant to buy the other.

A report from Barclays Capital drew attention to this link between mortgage-backed collateralized debt obligations and corporate debt-backed collateralized loan obligations (CLOs). The same investors buy tranches of the two types of credit pools and the degree of leverage and subordination are similar, Barclays pointed out.

CLOs are the biggest buyers of leveraged loans and a slowdown in CLO creation will drag down leveraged loans, said Jeff Meli, director of U.S. credit strategy at Barclays.

Investors have already moved away from more aggressive, less covenant-bound corporate finance arrangements. Today only higher-quality CLOs are going ahead, Meli said. The effect will probably spread from CLOs to new loan deals and from there to high-yield corporate bonds.

Contagion to other parts of the securitized credit market is likely as the full extent of hedge fund losses in subprime-related structured notes becomes clear. Because the instruments are traded sparsely, their prices often don’t reflect what they’ll fetch in the market.

Second Thoughts on CLOs

Hedge funds that bought CDO equity–the most risky tranche, which takes the first loss–did well as long as the market was stable, but are now paying for past gains. “They will think twice before they invest in a CLO,” said Mark Howard, co-head of research at Barclays.

Many hedge funds use models to generate prices for the structured securities in their portfolios, and there’s a temptation to use values that make the portfolio look better than if it were sold on the open market. Even with the best of intentions, illiquid CDO portfolios can be misvalued. The two Bear Stearns structured debt funds that collapsed this past June, for instance, turned out to have radically larger losses when outside dealers’ prices were used to value the assets.

“Clearly the weak link in this equation comes from the whole issue of marking-to-model as opposed to marking-to-market,” the authors wrote in the Barclays report. “This is especially the case for those hedge funds that are structured product-focused and which have endured significant losses in the subprime market. Further fund liquidations, followed by a drop in structured product demand, are certainly likely to have a knock-on effect on the overall structured product market.”

If raters and regulators find problems in the valuation of CDOs, there could be fallout for the pricing of CLOs as well. The key hazard is a drop in market liquidity and further risk reduction by investors, according to Barclays.

Ironcially, Barclays said it sees the weakness in credit markets as temporary and a buying opportunity–though some hedge funds deep in the red from CDO losses may not be able to participate.–Jeff Joseph and Chidem Kurdas