Carlyle, KKR Get Ready to Snatch Up Bargain Loans
(Bloomberg) -- Carlyle Group Inc., KKR & Co. and Oaktree Capital Management are among the money managers hoping to pounce on US leveraged loans increasingly selling at bargain prices.
The three firms are considering buying loans and packaging them into bonds known as collateralized loan obligations, according to people with knowledge of the matter. Many other fund managers are looking at doing the same: They’ve set up a near-record number of short-term lines of credit, known as warehouse lines, to purchase loans for CLOs, with about 286 open as of last count, according to strategists at Barclays.
“The opportunity is getting a little more exciting,” said Dagmara Michalczuk, co-chief investment officer at Tetragon Credit Partners, which invests in CLO equity. “A lot of folks are deciding to pull the trigger at the moment.”
Loans are relatively cheap now. More than 90% were trading at a discount to face value earlier this week, a higher share than any time in almost 18 months, according to strategists at JPMorgan Chase & Co. Later this week, that figure edged closer to about 85%, still an elevated level. Spreads on the debt are sitting near their widest of the past year.
The fear in the $1.5 trillion leveraged loan market is that higher borrowing costs and inflation will strain the weakest companies, triggering defaults. Even companies that might be less vulnerable are now getting caught up in those worries, said Ian Gilbertson, co-head of US CLOs at Invesco.
“The weakness in October initially started in more stressed and lower-rated loans, but more recently we’ve seen the selloff broaden into higher-quality names, creating a more attractive opportunity for CLO managers to put capital to work,” Gilbertson said. “This has encouraged some managers to accelerate new CLO formation.”
The demand for loans from CLOs could be a positive for at least some companies looking for financing now, at a time when the Federal Reserve is expected to continue raising rates and funding is harder to come by. CLOs own about two-thirds of the leveraged-loan market, making them the single-biggest type of investor in the debt.
Carlyle, KKR and Oaktree are just some of the firms that have recently talked to investors about selling CLOs soon as managers move quickly to capitalize on what could be a fleeting opportunity, according to the people with knowledge. Representatives for Carlyle, Oaktree and KKR declined to comment.
A big constraint in CLO sales is returns on the riskiest CLO securities, known as equity. Distributions for CLO equity have generally been falling for some time, but are averaging 2.8% this quarter, on track for the first quarterly uptick since 2024, according to a report this week by analysts at Deutsche Bank AG.
Even with that increase, distributions remain relatively low by historical standards. Cheaper loans are a positive for new issuance, but won’t necessarily trigger a torrent of new CLO sales. About $139.2 billion of new issue CLOs have been sold this year through Thursday’s close, down more than 16% from the same time last year.
Bargain loans help CLO equity in at least two ways: by paying higher yields from interest payments, and by generating extra return when they are repaid at face value. When a money manager buys a loan at, say, 97 cents on the dollar, and then eventually gets repaid at 100 cents, equity gets an outsized benefit from that price gain, because it offers leveraged returns.
Equity is often the hardest part of a CLO to sell, and rising returns for the asset class will probably make it easier to put CLOs together. The CLO arbitrage — the gap between what the vehicle earns on its loans and what it pays out to bondholders — has been ticking slightly higher as well in recent months. That gap widened to 1.41 percentage point this past week, up 0.07 percentage point from the prior week and above the 1.16 percentage point average for the past year, according to other JPMorgan strategists.
“In the long run, we always view bouts of volatility like this to be beneficial for CLO equity,” said Dan Ko, portfolio manager at Eagle Point Credit Management, which buys CLO equity.
The challenge for investors is to find loans that are trading below face value but still represent a good credit risk. There are some industries where technological changes are weighing on revenue and threatening to trigger more defaults. Cable-television companies, for example, are under pressure as consumers stream video over the internet.
“There’s a real separation between companies that can live with today’s cost of capital, and some companies whose capital structures were built in different environments,” said Michael Levitin, portfolio manager at MidOcean Partners.
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