Middle market collateralized loan obligations had a strong showing in 2005 and that performance is expected to continue into 2006, said Alla Zaydman, a director in Fitch Ratings' credit products group. She anticipates the average of 10-12 middle-market CLOs issued a year to continue, but expects to see more industry-specific middle-market CLOs.

Zaydman said the entrance into the middle-market CLO business has been largely prompted by the competition in the leveraged loan market. "We have seen leveraged loan managers going to the middle market, either using buckets or 50-50 [distribution] to take advantage of the spread because there is definitely more paper available in the middle market, which makes it easier to get collateral," she said.

Dan Smith at GSO Capital Partners said his group's most recent CLO is about 50% middle-market loans (see story, page 1). "We structure funds to be 50-50, where 50% are large syndicated names and 50% are smaller, middle-market names that are less liquid," Smith said. "We think having that liquid component allows us to manage the structure and gives us that flexibility so it is not completely illiquid. But with that mix we are comfortable having names that are higher yielding and have a nice risk-reward return." Smith and his colleagues first started working with middle market loans in 1998.

Fitch upgraded 17 CLO tranches in 2005 and 12 traches were paid in full. The upgrades were due to a higher credit enhancement because of deleveraging of the top-rated tranches. Zaydman anticipates a strong performance for 2006, but said the rate of upgrades may not be as robust as in the past, not due to collateral performance, but rather because of the emergence of new structures.