Companies bought by private-equity firms worldwide must repay the high-risk, high-yield loans and bonds by 2010, the Basel, Switzerland-based bank said in a report Friday, citing Fitch Ratings data. They may find it hard to raise the cash because of a slump in demand for collateralized debt obligations that pool the loans, BIS said.

Investors are shunning structured debt instruments such as CDOs, the main buyers of leveraged loans, after the credit-market seizure caused by the U.S. subprime mortgage collapse, the BIS said. The ability of LBO firms to refinance may be crimped further as banks tighten lending criteria after reporting US$402 billion of credit losses and asset writedowns.

“We’ve come out of an egregiously lax period in lending,” said Jamie Stuttard, who manages US$13 billion as head of European and UK fixed-income at Schroders Plc in London. “We expect an increase in defaults because of the wave of very leveraged LBOs.”

Defaults may be “significantly higher” than the average for corporate borrowers because of the leverage that buyout firms use to acquire companies, BIS said in the report, citing ratings companies’ year-end default-rate predictions of 4 percent.

Rising defaults

The default rate on high-yield notes worldwide rose to 2 percent in May, from 1.7 percent in April, and is likely to reach 6.3 percent by May 2009, according to Moody’s Investors Service.

“The risk of a significant increase in LBO firm defaults in the next few years may have risen substantially,” the BIS said. “With prospects for a recovery in demand from securitization vehicles in 2008 remaining uncertain and banks having little capacity to fund new loans, refinancing risk remains a key challenge for many LBO firms.”

Buyout firms typically borrow to finance about two-thirds of the cost of acquisitions. The debt they raise is rated below Baa3 by Moody’s Investors Service and BBB- at Standard & Poor’s.

“Some companies borrowed on the premise that they’d be servicing their debt in a time of economic growth,” said Stuttard. “That was somewhat dangerous given we’d already experienced four to five years of expansion and were therefore more likely to come toward the end of the economic cycle.”

CLO sales halve

Investors are demanding more in interest relative to benchmark rates to buy high-yield debt. The average U.S. leveraged loan yielded 413.2 basis points more than the benchmark London interbank offered rate this year, compared with 270 basis points at the end of 2007, according to S&P.

Sales of collateralized loan obligations, or CLOs, slowed to US$30 billion in the first quarter, less than half the amount a year earlier, the BIS said, citing JPMorgan Chase & Co. data. The total of outstanding CLOs expanded to almost US$250 billion in 2007, more than double the amount in 2004, according to the report, prepared by the bank’s Committee on the Global Financial System.

CLOs repackage loans into new securities with varying credit ratings and returns. The range of participants means it may take longer for holders of debt to get their money back after a default because of potential “friction” between different creditors during restructuring, the BIS report said.

“Agreements between creditors were often relatively easy to achieve when creditors were solely banks, but may be less straightforward when non-bank creditors are involved,” the report said.

LBO loan defaults may trigger forced sales by some CLO managers, putting further pressure on loan prices, the BIS report said.

The BIS was formed in 1930 and acts as a central bank for the world’s monetary authorities.

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