The CLO rally is not just explained by increased risk appetite but also by what has become a less threatening outlook for the sector than originally anticipated, Citigroup Global Markets analysts said in a report this week.

The ability of many high yield borrowers to refinance their maturing loans and bonds means that many of those immediate default candidates are no longer a threat, the analysts said. And the rating agencies have recognized this and have been gradually reducing their default forecasts.

The forecast for recoveries has equally improved. Realized losses are what hits loan pools, so default forecasts should be seen in conjunction with recovery values. And trading prices for loans that defaulted earlier in the year are significantly higher than where the loan default swap auctions were settled, the Citi analysts said.

The pace of downgrades to triple-C has also slowed somewhat. “Combined with higher prices and the outlook for short-term losses, the slowing downgrades mean that the CLO mezz bonds have a better outlook for final principal repayment as well as not being shut off from interest payments right away,” the analysts said.

However, the likelihood of a future spike in default rates needs to be factored into any decision for future investments. The slight easing in credit markets that led to recent refinancings, the analysts warned, might not be there in the scale required to meet the large volume of loans maturing between 2012 and 2014.

“In that case, defaults may decline in 2010 but could increase again,” they said. “Nevertheless, this seems unlikely to prevent the market rallying more still in the meantime.”

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