With the launch of its third CDO of CDOs, the $400 million Connecticut Value Structured Credit CDO III, Babson Capital Management has made yet another mark in what remains a niche market of the structured finance universe.
One of the most established firms in the overall CDO business, Babson is also a pioneer of the CDO of CDO business (it launched its first such structure in 2001), and has a team of highly seasoned professionals that continue to carry the business forward.
"We started buying in the CDO market in 1998 and 1999 because we had already been managing several CDOs," said Matthew Natcharian, head of Babson's structured credit team. "We had people who had been managing a range of CDO collateral from high yield bonds to bank loans and emerging market debt, and because they knew about the collateral and the structures that were out there, there was no reason why we could not participate in the debt or equity of another manager's deal if we found it attractive."
Babson has made it a point to focus on the quality of collateral and the strengths and performances of individual managers, Natcharian said, and this investment philosophy bears strongly upon all three of its CDOs of CDOs. In 2001, though, the CDO market was not as large or as developed as it is now, and availability of data was scarce. Babson therefore took upon itself the task of putting together a comprehensive database of information about the various CDOs on the market, which included data on collateral, structure and manager quality. Over the years, the database - now known as CDO World - has grown extensively, evolving into a proprietary analysis and monitoring system designed to capture the performance of CDO portfolios, Natcharian said.
With the help of CDO World, Babson has been able to put together a series of structures that take the best of what is available at different points in the market cycle. Focusing on bank loans and high yield bonds as collateral - areas in which it has the greatest expertise - the firm is able to participate in all tranches of a CDO deal, from triple-A to equity, Natcharian said.
"We use all the data we have to quantitatively analyze a deal's collateral pool and see where the risks might lie," he said. "We then discuss those risks with the collateral manager and talk to our own teams to see whether a particular portfolio is strong and has been well structured. We'll also make sure that a manager and his portfolio are in sync style-wise and will last over time."
As a firm, Babson has preferred to go with higher quality collateral for its CDOs of CDOs, and all three of the Connecticut Valley structures have an average rating in the triple-B to triple-B-minus range, Natcharian said. But this aside, the advantage of the CDO of CDO is that it offers a greater protection against the effects of an increase in defaults.
"The equity return profile of a CDO of CDOs is flat, whereas that of a CLO is more like a steep, diagonally sloping line," Natcharian said. "A CLO might have exposure to 100 names, but if one defaults, the equity can get hurt at the margins, and if many default, the equity will be wiped out. If you own a triple-B tranche of a CLO, though, you don't get hurt until there have been a lot of defaults because you have resecuritized a portfolio of triple-Bs that don't let equity get hurt until defaults reach a pretty high level."
Despite these qualities, though, the CDO of CDOs business still remains relatively small, with just a few participants. Of course, the overall growth in the CDO market has created more opportunities for a greater number of players, Natcharian said, and one can expect the CDO of CDOs business to grow.
Even so, while the increase in the number of CDOs is expected to continue, there are some red flags that need to be raised, the negative effects of which could come to bear upon the CDO of CDOs business, too, if one is not careful enough.
"We're at a point in the credit cycle where spreads have become very tight and it is increasingly difficult for collateral managers to source credits at attractive spreads that they are comfortable with from a credit perspective," Natcharian said. "At some point in time, pricing and credit will deteriorate. In this cycle, we are sticking with the best managers, as we believe they will have the best access to credits based on their expertise and reputation. We are always conservative, but we are being defensive in this tight market."
Babson manages between $4.5 billion to $5 billion in CDOs across all of its accounts, of which about $2 billion is in CDOs of CDOs (in addition to the three Connecticut Value structures, Babson has also put together a $1 billion high grade CDO of CDOs, with an average rating of double-A). Overall, the firm manages $17 billion in structured credit assets.
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