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.
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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.