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CDOs Return, as a Hybrid of Junk Bonds and Leveraged Loans

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A reborn version of collateralized debt obligations, backed by both high-yield bonds and leveraged loans, is gaining ground just as concerns about credit markets are on the rise.

These hybrids have characteristics of the very first corporate-bond CDOs beginning in the late 1990s, but they are far less leveraged — three times compared to 11 to 12 times for the first generation, according to issuers. They are not related to the mortgage-backed bonds that contributed to the financial crisis. Yet worries remain.

(Related: CLOs Are Hot. Plan Accordingly.)

The bonds are largely investment-grade, structured with lots of credit protection, and pay a fixed-rate coupon, unlike current collateralized loan obligations. They also have maturities of five years or more. Because of this, buy-and-hold investors such as insurance companies seem to have taken to them, according to data compiled by Bloomberg. Also, issuers say that they can adjust the asset mix during the life of a deal to profit from interest rate gyrations over the next several years, while keeping liability costs fixed.

However, people also point out the higher amount of junk-rated bonds means the assets have lower recovery rates than deals backed mostly by leveraged loans. Moreover, Moody’s Investors Service says that up to 17.5% of the assets in these structures can be comprised of Caa-rated assets, whereas a typical CLO has a purchase limit of 7.5%.

And the timing of the proliferation of these assets could be problematic. “As we head towards the end of the credit cycle, is now really the best time to buy this kind of structure? Because in a downturn, these things may take a lot of pain,” said Jason Merrill, a structured finance analyst at Penn Mutual Asset Management.

GSO/Blackstone Debt Funds Management LLC sold a $616 million CDO backed by leveraged loans and junk bonds on Nov. 5, the fifteenth since these sales started in 2015. There’s been more than $3 billion of the transactions since the beginning of the year.

“Some of these deals have tremendous flexibility to add bonds, like 75% or 100% bonds,” Merrill said. “So, as an investor, you could think you’re getting a 25% to 50% bond deal but sooner rather than later, the manager could crank that number higher.”

— Read Citi Leads CLOs as `Better Mousetrap’ Resets Take Offon ThinkAdvisor.

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