Private Equity Firms Eye Discounted US Loans for Bundling

Carlyle Group Inc., KKR & Co., and Oaktree Capital Management are preparing to buy US leveraged loans that are selling at discounted prices. The firms are considering purchasing these loans and packing them into bonds known as collateralized loan obligations, or CLOs. Other fund managers are also pursuing this strategy by setting up a near-record number of short-term credit lines, known as warehouse lines, with about 286 open according to Barclays strategists. Prices for loans have dropped recently. More than 90% of loans traded at a discount to face value earlier in the week, marking the highest share in almost 18 months, according to JPMorgan Chase & Co. strategists. That figure later moved closer to about 85%. Debt spreads are currently near their widest points of the past year. Market fears over higher borrowing costs and inflation are driving this trend. The anxiety is that weaker companies will face default risks. In October, selling started in lower-rated loans before spreading to higher-quality names. This broader selloff has created an opportunity for CLO managers to put capital to work and accelerate new CLO formation. CLOs represent the single biggest investor group in the debt market, owning about two-thirds of it. Demand for these loans could offer financing help to companies at a time when the Federal Reserve is expected to keep raising rates. Representatives for Carlyle, Oaktree, and KKR declined to comment on the matter. Returns on riskiest CLO securities, called equity, have been a constraint. Distributions for CLO equity are averaging 2.8% this quarter, marking a first quarterly uptick since 2024 according to Deutsche Bank AG. About $139.2 billion of new issue CLOs have been sold this year through Thursday's close, which is down more than 16% compared to the same time last year. Bargain loans help CLO equity by paying higher yields from interest payments and creating extra returns when repaid at face value. The gap between what the vehicle earns on its loans and what it pays out to bondholders, known as the CLO arbitrage, widened to 1.41 percentage points this past week. Despite these opportunities, investors face challenges in identifying loans that trade below face value while maintaining good credit risk, particularly in industries facing technological changes like cable-television companies.

Context

Collateralized loan obligations bundle corporate debt and sell slices of it to investors with varying levels of risk and return. Market volatility often creates buying opportunities for distressed assets when debt prices fall below face value. This dynamic allows fund managers to seek higher yields despite broader economic pressures.