Unsettled structured credit markets are causing investors to become more scrupulous in their collateralised debt obligation (CDO) manager choices, according to market participants.CDO markets have been knocked by snowballing delinquencies in the US subprime mortgage market. Despite the continuing soundness of much of their underlying collateral, investment-grade corporate CDOs have not gone unscathed by the crisis. By November 20, the five-year on-the-run iTraxx 3-6% index tranche, representing mezzanine European investment-grade corporate CDO paper, was trading at 175 basis points. On January 2, the on-the-run iTraxx 3-6% index tranche was trading at 30bp.
A rise in perceived credit risk and a breakdown in secondary liquidity across structured credit markets are making investors more cautious about investing in CDOs. In particular, they are becoming choosier about the collateral managers overseeing deals, which have the ability to swap out credits and often trade names in the underlying portfolio.
“There’s really a bifurcation between those who can get a deal done and those who will take a deal at any price. And you’re seeing that more now than ever before,” said Jason Schechter, New York-based global head of CDO trading at Lehman Brothers.
Having lost billions of dollars on subprime mortgage-linked and warehoused CDO assets, dealers are also cautious about taking any assets onto their balance sheets that they might not be able to later unload.
On November 7, New York-based Moody’s Investors Service reported that, by the end of October, the global speculative-grade default rate stood at 1.1%, its lowest level since March 1995. The agency predicts this will rise to 3.6% by October 2008.
As the credit cycle turns, CDO arrangers and managers said it would become easier to differentiate between managers that were adding value and those that were not.
“When everything’s grinding tighter on a week-by-week basis, it’s very hard to tell which manager did better than the other,” remarked Kathy Sutherland, head of JP Morgan’s global structured syndicate team in London. Contrastingly, she added, rougher credit markets would produce greater differentiation between managers.
Some CDO managers welcome the prospect of higher defaults, believing it will help bolster their claim that they add more value to transactions than competitors. One US-based CDO manager who spoke to Risk said it would separate value managers from “incompetents” and “amateurs”.
But Lehman’s Schechter said it was also important not to "bind the hands" of good CDO managers through excessively strict trading rules, especially in turbulent market conditions.
“There are certain investors that always want to limit the trading flexibility of a manager when things like this happen. It is better to give the manager more flexibility rather than less, especially when the market is potentially facing a period of disarray.”
A recent report by Moody’s also stressed the significance of management fee and incentive structures to the performance of CDO managers. “The alignment of interests between the manager and noteholders is critical to ensuring the flexibility granted to the manager is used in a way that is not detrimental to the rating and noteholders’ interests,” it said.
In general, studies by analysts at both Citi and Derivative Fitch suggest managed synthetic CDO deals exhibit lower ratings volatility than static ones.
According to Citi, managed synthetic CDO tranches rated by Standard and Poor’s (S&P) underwent fewer ratings upgrades between 2004 and 2006, while credit conditions were favourable. On the other hand, S&P-rated managed synthetic CDOs experienced fewer downgrades during the credit downturn of 2003. Analysts at the bank expect investors to demand more managed deals in future as credit conditions take a turn for the worse.
The recent performance of some managers in the CDO of asset-backed securities (ABS) sector, however, might give them pause for thought. On November 21, Derivative Fitch lowered the CDO asset manager (CAM) ratings of six CDO managers, including Connecticut-based GE Asset Management, Rabobank and California-based Trust Company of the West. It placed another four on watch for a possible downgrade, including London-based Solent Capital.
The CAM ratings reflect Derivative Fitch’s assessment of the firms when managing CDOs of ABSs only. Manuel Arrive, a director at the agency in London, said it was difficult to tell whether the downgrades would affect their performance in managing other CDOs referencing corporate bonds or loans.
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