Sankaty Advisors LLC, the credit unit of Bain Capital LLC, is buying more lower-rated bonds of collateralized loan obligations to take advantage of higher yields, according to managing director John Wright.
CLO debt rated BB is paying average spreads of about 625 basis points more than the London interbank offered rate this month, the most this year, according to the Royal Bank of Scotland Group Plc (RBS:US). That compares with spreads on the AAA slice of the funds which bundle and sell junk loans, which have tightened to about 144 basis points, a 2014 low. A basis point is 0.01 percentage point.
While there has been no shortage of new-issue mezzanine investment opportunities, the buyer base hasn’t grown much, resulting in “pretty wide” spreads and presenting a “compelling opportunity,” Wright said in a telephone interview. Sankaty has been purchasing more of the debt in the past few months, he said.
BB debt may be protected from defaults because equity and sometimes a B rated slice will take losses first, said Wright, who is based in Boston. It is also typically issued at a discount and may offer a yield of 8.5 percent.
CLOs pool high-yield corporate loans and slice them into securities of varying risk and return, typically from AAA ratings down to B. The lowest portion, known as the equity tranche, offers the highest potential returns and the greatest risk because investors are the first to see their interest payouts reduced when loans backing the CLO default.
JPMorgan Chase & Co. and Wells Fargo & Co. are forecasting that as much as $100 billion of CLOs will be arranged this year.
The past two years had seen plenty of mezzanine-debt buyers and not enough AAA investors, Ken Kroszner, head of CLO strategy at RBS, said in a telephone interview.
Now “it’s been a role reversal,” he said. “AAAs aren’t as hard to sell while mezz debt has become harder” to place.
After mezzanine bonds tightened in January to 560 basis points from 610 basis points in December, investors began to back away from the market, said Kroszner, who’s based in Stamford, Connecticut. Now, even as spreads have widened and become more attractive, mezzanine supply continues to outweigh demand.
“Even though the mezzanine debt is more expensive, it is a relatively small part of the capital structure,” Wright said. AAA spreads drive the economics of the deal, so even if the bid for mezzanine tranches is weaker, the CLO can still work.
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