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A boom-time debt product is back with a vengeance

January 11, 2013: 10:15 AM ET

Collateralized loan obligations virtually disappeared after the crisis. Investors are clamoring for them again.

By Lauren Silva Laughlin

FORTUNE -- Who said all fancy debt products abbreviated by a three-letter acronym were risky? Collateralized loan obligations, or CLOs, had all but been relegated to the graveyard with other structured securities popular during the debt binge of the last decade (CDO, MBS, CMO…the list goes on). Between the fourth quarter of 2008 and the first quarter of 2010, less than $3 billion of CLOs were issued, versus nearly $100 billion at the market peak.

But CLOs are back with a vengeance. In 2012, $55 billion of new CLOs were issued, more than the total combined issuances between 2008 and 2011, according to JPMorgan. S&P Capital IQ LCD says the market could top $90 billion if the fourth quarter run-rate holds up, nearing its peak. And it looks like it will. For every one investor who will sell a CLO, 10 investors will buy one, according to recent statistics from JPMorgan.

As it turns out, CLOs weren't as damaging as their debt product cousins. They actually held true to what they always touted. Returns are higher – and investments less risky – than buying individual loans.

CLOs work something like this: Managers buy around 150 loans, many used to finance private equity buyouts, and package them into one pool. Investors (institutions, not individuals) buy portions of this pool, which offer different payouts and restrictions depending on the level of risk taken. At certain times, if the underlying loans start to struggle, the fund conserves cash by keeping payouts from those holding the riskiest part of the CLO. The manager can then use that cash to buy new loans. It prevents the liquidation of the fund during troubled times.

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"Non-investment grade leveraged loans within the CLO structure have proven to be very resilient in times of stress," says Linda Pace, head of the U.S. structured credit team at Carlyle Group, the Washington-based asset manager who has issued five CLOs since 2011. "While it was very scary during the recession because asset prices fell to unprecedented levels, in hindsight, investors look at CLO performance and see that the returns are impressive."

Indeed, investors who held onto their CLOs have done quite well. CLO equity holders posted 17% cash returns on average from 2006 to 2011, according to JPMorgan. Performance more recently has been good too. On Tuesday, Carlyle released preliminary return information for the fourth quarter last year. The Global Market Strategies division, in which structured credit is the largest group, was up 23% year-over-year.

The structure isn't dissimilar from one used with mortgage products that burned investors. But the leverage loan market is healthier. Underwriters often keep some loans themselves, so they have incentive to issue the better ones. CLOs are also meant to be actively-managed. Unlike mortgages that were unsupervised, managers buy and sell leveraged loans in their portfolio on a regular basis.

"There was nothing wrong with the underlying product," unlike other debt instruments, says Rishad Ahluwalia, CLO analyst at JPMorgan (JPM) and author of its report. "This is simply corporate credit assets, and there haven't been a whole lot of real changes to the CLO structure."

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Another aspect proved true: CLOs are actually less risky than investing in individual loans. CLO collateral defaults peaked at 6.5% in June 2009, according to Carlyle, versus an overall 8% default rate in November 2009, according to S&P Capital IQ LCD.

This is probably why the market is making a comeback. The main problem, now, is that CLOs may have a dearth of deals to buy. CLOs are partly made up of debt being lent to private equity deals. And while private equity firms are stymied if the leverage loan market is slow, a better leveraged-loan market doesn't necessarily mean that buyouts will be abundant.

"That's the conundrum the market is facing," says Steven Miller, analyst at S&P Capital IQ LCD. "The CLO market greases the wheel for financing, but it can't create opportunities. There is not a ton of new deal creation in terms of leveraged buyouts."

Firms like Carlyle, who also have large private equity funds, do create the opportunities, so they stand to profit two ways. In the past, this was seen as an area for potential conflict, because debt and equity investors can be odds when deals go awry. But if CLOs can weather a large recession, and they have, the conflict doesn't arise, and neither equity nor debt investors are likely to care.

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