CDO market looks to a broader asset base

Collateral

The collateralised debt obligation (CDO) markets in the US and Europe are taking divergent paths this year. While volumes are expected to remain broadly flat in the US, dealers expect another year of growth in Europe. On both continents, innovation in the form of structural enhancements required to protect the interests of increasingly discerning CDO investors may help spur activity.

Dealers believe the market’s development is likely to depend on the inclusion of new asset classes such as US municipal debt in CDO structures. There is currently a push in this direction in both the US and Europe, although there is a lack of consensus about the reasons behind it. But fundamentally, CDO structurers see it as one way to resolve the conflict between the under-performance of some traditional CDO collateral and investors’ demand for performance.

Some believe the shift towards including new types of collateral in CDOs has broader origins. Brad Craighead, London-based managing director and head of structured trading at JP Morgan Chase, says it isn’t so much investor demand for more secure assets, but the natural evolution of the market.

Exhausted potential
Craighead says CDOs have largely exhausted their potential using traditional assets such as corporate bonds, which have formed the backbone of the market to date. Though investors may now have adequate exposure to these assets, he thinks there is no reason why other assets can’t be fair game. “The CDO concept applies equally well to a variety of [asset] classes, and where clients don’t have exposure to those classes then a CDO is an efficient way to achieve it.”

In the US, rating agency Moody’s predicts volumes will remain roughly constant against $65.1 billion new issuance in 2002. London-based analyst Katherine Frey says the US market has been depressed by a struggling corporate sector, which, in turn, has driven a number of structural reforms to CDOs (see article, page S12) partially aimed at mitigating the impact of rating downgrades. Last year, investors generally turned away from the corporate CDO market in favour of collateralised loan obligations (CLOs). In the latter category, dollar volumes picked up by 14%.

In Europe, by contrast, Frey says the CDO market boomed, and Moody’s expects more of the same in 2003. A 42% growth in volumes over 2001 with a total of $182 billion of credit risk transferred was hallmarked in particular by the take-off of the synthetic market. Synthetics accounted for 95% of deal volume and 85% of total deals.

In Europe, Frey says investor focus lies firmly on the stability of the asset, with asset-backed securities (ABS),

residential and commercial mortgage-backed securities leading the way in a growing number of both synthetic and cash deals.

She says leveraged loan CDOs and collateralised loan obligations are particularly popular with US investors at present. This is due to their ability to generate cashflow – an area in which the domestic high-yield bond market is struggling. Europe, she says, is following suit, and she anticipates significant new issuance in this class in the second and third quarters of this year.

The fact that almost half the cash CDOs launched in 2002 were resecuritisations reflects investor appetite for higher quality, more stable assets. Frey expects securitised assets to become increasingly esoteric in 2003, including project finance CLOs and distressed asset CDOs. She also says a number of CDOs of private equity are now in the pipeline, and anticipates a growing number of project finance CLOs backed by leveraged loans – assets which to date have shown ratings stability. Though few such deals were completed last year, Frey says many are now nearing launch.

Mitch Braselton, New York-based managing director and head of global structured products at Bank of America, says some demand for asset-backed securities is coming from buyers of senior CDO tranches. “Because traditional investors are reluctant to invest in these tranches, spreads have widened and made them attractive for CDOs of CDOs,” he says. In fact, Braselton says one result of this is increased demand for more arcane structures. He notes: “We recently had a specific request for a CDO of small and medium-sized enterprise debt that would provide exposure to Scandinavian and Portuguese risk.”

However, Braselton believes there are limitations on what can be effectively packaged in a deal. He says, for instance, that convertible bonds are difficult to package in CDOs because low coupons do not produce sufficiently viable current yields, making it difficult for the resulting CDO to generate the cashflow necessary to service debt.

In one deal, however, Bank of America circumvented this problem by augmenting distressed debt with ABS within the CDO. “High quality ABS added dependable cashflow without adding material risk,” says Braselton. This funded the liabilities while BoA waited for the core distressed debt to add cashflow. Braselton believes this sort of innovative approach – what he calls “credit deals with a twist” – will become common as the market continues to evolve.

Towards value
Braselton says investors are now particularly interested in clean leveraged loan deals, and place an increasingly high premium on “manager’s name”. “There is a move away from reaching for yield and towards value,” he says, adding: “Prominent manager names are needed to make deals sell smoothly. Where a deal doesn’t have the right manager with a good track record, investors will walk away.” He believes that, in addition to asset-backed deals, CDOs of CDOs may also become popular, particularly for mezzanine investors looking to take advantage of the current dislocation and to more effectively manage risk.

JP Morgan Chase’s Craighead says that while there has certainly been a trend towards CDOs of ABS and structured products in 2002, there are few asset classes that don’t make sense from a structuring perspective. In fact, he believes “the potential of new asset classes is driving the development of the CDO market at least as much as investor demand”.

CDOs of private equity, trust-preferred securities, middle-market loans and distressed debt have all emerged in the past 12 months, and Moody’s predicts that US municipal bonds will become a key asset class in the coming year.

Craighead believes that what is important to investors is the ability to diversify risk exposures through an efficient and cost-effective vehicle. He says European investors in particular want exposure to US assets, and CDOs allow that to be achieved cost-effectively through “subcontracting to a proven manager where it is not viable for the investor to go it alone”. This, he thinks, is the primary driver in the market’s growth.

Craighead agrees that in Europe, leveraged loans have been the CDO sweet spot to date, but he contends that there is a ceiling on how far this market can develop due to the fact that most deal sizes are insufficient to back CDOs in size. He confirms that ABS CDOs are viewed as desirable by investors, but says this will not necessarily result in a spate of new products. “It takes time to get the necessary diversification,” he says. “And there is also a scramble to find collateralisation.” Furthermore, he believes the value of the asset manager can be diluted by the limited number of credits available. He also believes a CDO of commercial mortgage-backed securities may be one likely trend in the year ahead.

Broadly, Craighead’s view of some other prospective assets is that many of those being touted as new are in fact old hat. He points out that distressed and convertible CDOs are not inherently new, and sees no reason why more should not be forthcoming in 2003 if coupons improve and the necessary spreads can be achieved. He also notes that “when a CDO of hedge funds was first introduced, investors were worried about the perceived stability of the assets. But as time has proved the performance of these products to be viable, investor appetite has grown.”

Nevertheless, Craighead says some investors are still focused on identifying safer havens, and US municipal debt may provide one of these, with European investors likely to be interested. Particularly for inclusion in synthetic CDOs, Craighead says the advantages of municipal debt are clear. Municipal investing is tax-free for individual investors, and the credit standing of cities is better than for comparably rated companies. Additionally, US municipalities are
facing significant deficits, so they will be looking to borrow heavily in 2003. It would not, he adds, be difficult to develop diversified CDO portfolios of these assets.