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Bundled debt demand reaching height of crisis

Tracy Alloway
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Sales of bundled U.S. corporate debt known as collateralized loan obligations are on course to surpass levels reached at the height of the credit bubble, as the relentless search for yield leads investors to abandon caution.

The sales illustrate the rise in risk-taking by investors recently burnt in the financial crisis. In addition to renewed appetite for CLOs, private equity firms are buying out companies at record highs and investors are snapping up repackaged subprime U.K. mortgages that lenders are eager to get off their books.

Sales of CLOs, which pool leveraged loans made to low-rated companies, dried up in the years after the global crisis but have since come roaring back as investors seek out the higher returns on offer from buoyant credit markets.

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While corporate defaults have so far been rare amid continued low interest rates, regulators including the Federal Reserve have been warning that parts of the credit markets – including leveraged lending – risk overheating.

Sales of CLOs in the U.S. so far this year have reached $42 billion and analysts are upping their full-year forecasts to as much as $100 billion, which means issuance could easily surpass the $89 billion sold in 2007 and potentially even the $97 billion sold at the CLO market's peak in 2006.

The CLOs sold now, known as "CLO 2.0s", differ from their pre-crisis predecessors. Bankers pack the second generation of the products with additional financial support and have stricter rules about underlying collateral that are meant to make the securitizations safer.

"I'm feeling more demand right now than I think I've ever felt in the 2.0 product," said Brad Larson, who heads the CLO business at Credit Suisse.

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Selling the least risky but lowest-yielding slices of CLOs has always been the trickiest part of the business, but bankers say that new buyers including hedge funds and some European institutions have emerged to purchase these triple A rated senior tranches.

Mr Larson said: "I certainly could see $90 billion-$100 billion this year. Triple-A demand is back in a pretty big way. We've seen new buyers in the space and some old buyers come back in."

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Strong sales in recent weeks have surprised many market participants, who at the beginning of this year forecast sluggish issuance in the face of headwinds including new regulation and technical factors such as tighter credit spreads.

The Volcker rule could force banks to sell their holdings of non-compliant CLOs, though they have until mid-2017 to comply after the Fed granted them an extension last month. Bankers have already been creating "Volcker-friendly" CLOs, which banks would be able to hold under the new rules.

In recent weeks, the chief investment office at JPMorgan Chase, traditionally one of the big buyers of CLOs, is said to have resumed buying after a lengthy hiatus.

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The CLO market has also received a fillip from a reversal of fortune in the retail market for leveraged loans, which competes with the structured investment vehicles to buy the assets.

April saw the first outflows from leveraged loan funds in almost two years, depressing loan prices and making it cheaper and easier for CLO managers to source new assets for their products.

Analysts at Morgan Stanley have increased their expectations for full-year issuance from $55-65 billion to $75-80 billion, while their colleagues at JPMorgan have upped their forecast from $60-70 billion to $90-100 billion.

Sales of CLOs reached $81.8 billion in 2013, the highest since 2007 according to data from S&P Capital IQ.