The days when each new corporate default sent collateralised debt obligations’ credit ratings into freefall appear to have become a dim memory in the collective consciousness of the structured credit markets. Spreads on CDO tranches have recovered across the board, and the secondary market has sprung to life to the point where traders say CDOs are an asset class in their own right.
Three years ago it was rare that CDOs would trade at all, and now some traders are doing upwards of 15 trades a week. Investors’ search for yield, increased transparency, better deals and better analytics as well as a commitment from dealers to the CDO market have all contributed to the secondary market’s development.
A powerful factor in really kicking off the market in 2003 was the disposal of Abbey National’s multi-billion dollar CDO portfolio. “I think Abbey’s disposal really jump-started the market. There was enough paper for a lot of different players to care. It suddenly felt like something more than a one-off market,” says Mitch Braselton, head of North American structured products management at Morgan Stanley in New York. “The volume encouraged both dealers and investors to get their systems running so they could quickly react to liquidity in the market.”
Aside from supply flowing into the market from Abbey, traders report that significant amounts of CDO tranches were sold on the secondary market by insurance companies. Since the CDO spreads reached all-time wide levels in 2001 and 2002, the market has recovered significantly, giving investors the chance to exit positions. Today, new supply continues to hit the market, particularly CDOs backed by asset-backed securities (ABS) and CDOs backed by loan portfolios.
With single-A US corporate credits trading at around 30 basis points, and triple-Bs at 60–100bp over traditional fixed-income, investors have turned to CDOs for yield. “The largest driver of improved CDO liquidity is a dearth of anything else with yield. Anyone who buys fixed-income products is now involved in CDOs,” observes one US-based CDO trader.
Typically, a triple-A tranche of a US investment-grade CDO will trade around 60bp over Libor, but in some cases such as CDOs with loans as underlying collateral, triple-A tranches will trade between 35bp and 38bp over; investors have gone down the credit curve and demand for mezzanine tranches is growing. Still, CDOs are one of the widest-trading credit types mainly because of the amount of credit work needed to be done in terms of understanding deals before investing.
Types of investor
Insurance companies are still investing in CDOs after having sold off some older vintages for newer deals, and now money managers and hedge funds have climbed into the ring. Over the past two years, hedge funds have made their presence felt in the CDO market, especially by buying up distressed tranches.
Hedge funds have come into the market using their expertise in the underlying collateral and applying that to CDOs. “More than anything else their experience has been high-yield bonds, which has become an obvious opportunity for them, in particular, CDOs that are trading very distressed relative to the underlying market,” says Ross Heller, head of global CDO trading at JPMorgan in New York.
Hedge funds have targeted beaten-down senior tranches of high-yield CDOs trading at 15 cents in the dollar or less, analysing the underlying credits and the structure of the CDO, to determine whether they could essentially buy the portfolio much cheaper than if they created the portfolio themselves in the market.
Perhaps the most common hedge fund trade has been the carry trade. Hedge funds entered the market at the triple-A level and leveraged up the trade by 15 or 20 times. To a lesser extent, hedge funds that required less liquidity and could afford to wait up to four years to see their investment grow, bought into distressed emerging markets transactions at between 20 and 40 cents in the dollar. Some of those emerging markets deals are now trading close to par, and in a few cases hedge fund managers who got in at 20 cents have had returns from 300–400%, according to one hedge fund manager.
“On a cashflow basis this wasn’t a very attractive trade for those looking to hit singles; these were trades for guys looking to hit home runs. They recognised that the market had essentially bottomed out for these deals and there wasn’t too much more downside. They also recognised that things had started to improve and if you just use a mean reversion type of mentality, these deals were totally undervalued,” says a hedge fund manager who invests in CDOs.
Now some hedge funds that bought distressed high-yield CDO paper have sold them as liquidity has improved and taken the profit. “What they can do is either sit back and enjoy it, or if there are certain names in the portfolio they didn’t like, they can hedge away risk on those names, and that’s where they use their expertise on the underlying,” says JPMorgan’s Heller.
Hedge fund Highland Capital Management in New York is pursuing a buy-and-hold strategy through its CDO Opportunity Fund. Highland was an early entrant to the CDO market and its fund has been running for nearly two years. It invests in CDO mezzanine and equity tranches and uses modest amounts of leverage.
“A growing number of investors are interested in the CDO market. Moreover, our existing clients are expressing interest in a broader range of underlying assets and increasingly migrating down the capital structure of CDOs,” says Dansby White, managing director and senior portfolio manager at Highland. He says mezzanine and equity pieces offer value for firms such as Highland, who are willing to do the labour-intensive credit work needed to get to understand each deal.
Hedge funds have also been active in synthetic CDOs as well as correlation trading, which has boosted secondary activity on that side of the market too. “Hedge funds can be major players in the correlation business as they are uniquely positioned to trade correlation products with a real credit bent. For example, they can go long a distressed secondary synthetic position, then hedge specific credit risk within that position to generate positive carry. It really is a liquid two-way market now,” says Morgan Stanley’s Braselton.
Credit traders from investment banks have created new hedge funds purpose-built to do this kind of trade, observes Olivier Vigneron, director in structured credit trading at Deutsche Bank in London. “Hedge funds are becoming credit correlation experts, much like prop desks,” he adds.
It is not just hedge funds that have seen value in CDOs. Investors are starting to trade CDOs just like any other credit type. “There are close to a trillion US dollar-denominated CDOs out there. People do buy-and-hold, people do relative value, capital structure arbitrage trades, buy-and-hedge trades. Just like any other market, people try to do anything possible to be creative,” says one senior trader.
Heller says JPMorgan is actively trying to foster relative-value trading among its clients, where they trade in and out of positions to pick up basis points. “We are trying to create and provide analytics and give insight into fair value and relative value. For example, we may recommend one part of the capital structure versus another,” says Heller.
Total return managers are entering the CDO market and boosting trading volumes, but one hitch is that the vast majority of the paper available is triple-A rated and does not move around very much. Total return managers target lower-rated tranches, which tend to be scarce: for example, a $500 million CDO may only have $25 million in triple-B paper. But that’s where the value in the market is.
Investment banks – on a relatively limited basis – have been synthetically creating exposure to mezzanine tranches of CDOs using total return swaps, which is starting to increase the amount of risk that is represented by the mezzanine tranches of CDOs despite the fact the risk does not exist in cash form. “We have excess demand in the market to buy mezzanine risk, so there’s lots of investors, there’s funds, vehicles and insurance companies who are interested in buying this risk,” says Heller.
A total return swap on a CDO tranche works because it can mimic the exact cashflows in the CDO it references. An owner of, say, a $10 million CDO tranche can create a contract with another customer paying the exact same cashflows as if they owned that particular $10 million piece of a CDO. The CDO owner pays the coupon and principal at maturity and the buyer of the total return swap pays $10 million to the owner of the original CDO. The investor that owns that risk synthetically gets the same cashflow as if they owned that CDO.
Two years ago, the common response to whether CDO liquidity would ever materialise was that before anything could happen the market needed more transparency. Until recently, deal information was restricted to underwriters and investors. If an investor outside a deal were interested in buying in, the chances of finding any information to use to vet the deal were slim.
Slowly, dealers began making deal information widely available through services such as Intex Solutions in Massachusetts and New York-based Wall Street Analytics. Both have analytical tools widely used by investors and investment banks to model CDOs trading in the market. Bankers and investors credit these services with bringing transparency to CDOs and bolstering the secondary CDO market.
Intex has both web-based and Windows-based programs that read the data in the deal model files and monthly update files it creates. It also allows clients to run stress scenarios, generate cashflows based on their own default and recovery scenarios and also create other various price-yield analytics. Intex has a database of over 800 CDOs, which represents the vast majority of issuance to date.
“The other thing I think that’s fostered the secondary market is not just the fact that Intex has these deals now modelled but also the fact that underwriting dealers have granted access to these deal models on Intex. That’s a reversal of where this market started, so two or three years ago Intex had a large number of the deals modelled, clients had to go through the lead underwriter and get permission to view the deal on Intex,” says Jim Wilner, vice-president at Intex.
Intex plans to add information on more European CDOs to its service, and to expand its model to include synthetic deals.
CDO traders are optimistic that the secondary market in CDOs is here to stay. Liquidity will always be very good because there are too many holders of CDO paper out there who recognise the paper’s relative value. “Obviously in poor credit cycles, bid-offer spread tends to widen, but two or three years ago, there were periods where there was no bid overnight. That will never happen again,” says a senior CDO trader.
“Secondary CDO market liquidity is sustainable as there will always be sellers of distressed CDOs and opportunistic buyers. The drive in the future will continue to be the search for spread as well as arbitrage opportunities, says Laila Kollmorgen, a CDO and ABS trader at BNP Paribas in London.
“The CDO market in general in the credit space is becoming more and more synthetic. Comparing the number of synthetic deals versus cash, it’s clear that this sector is growing every year by leaps and bounds. The sheer number of deals can only increase liquidity in the secondary market,” says Martin St Pierre, global head of structured credit derivatives trading at Bear Stearns in London.
Despite the fact that distressed CDOs of ABSs have been largely ignored by vulture buyers for the past three years, the newer vintages of CDOs of ABSs are thought to be where the next big wave of liquidity will come from in the market.
JP Morgan’s Heller says: “The next real leg of this market in my mind will be the increased liquidity in structured finance CDOs and that’s the next place where we’re going to find value. That’s where bonds are trading cheap now, that’s where doing the work is going to give you some value that’s not necessarily there in other asset classes.”
This article originally appeared in the October issue of Risk magazine