Following a flood of deals in mid- to late-October, issuance of arbitrage collateralized debt obligations could be winding down for the year, as managers are finding it more difficult to place the equity in today's market, bankers said.
Though several more deals are scheduled to close this year, a number of them will get pushed into January.
Meanwhile, as part of a seasonal shift, the pipeline for balance-sheet and synthetic CLOs continues to grow, potentially flipping the ratio that has, year-to-date, been heavily weighted on the arbitrage side.
For example, in the third quarter, of the 38 CDOs Moody's Investors Services rated globally, only three were balance-sheet CLOs, the agency said in a recent report. Moody's attributed that to a decline in European third quarter activity, where the issuers generally prefer to launch in the fourth and second quarters for financial statement reasons.
Currently, Fitch is looking at 30 deals that could close before year-end, only a small portion of which are arbitrage deals, the rest being balance-sheet and synthetic CLOs, the agency said.
"How many of them actually close, I don't know," said Brian Gordon, an analyst at Fitch. "How many of them go over into January, I don't know. Some of them might never even see the light of day."
Similarly, Moody's anticipates a heavy pipeline of CLOs going into December.
"At the same time though, I think a non-trivial number of arbitrage deals will get done in December," said Jeremy Gluck, a managing director in the CDO group at Moody's. "Last year we saw this game where everyone said the market would wind down because of Y2K, and then suddenly a flurry of deals got done in December."
Placing Equity
While some arbitrage deals are getting pushed into the new year, the same market that's making it difficult to place equity is making collateral dirt cheap, and creating what some are calling the best arbitrage opportunity in at least two years.
"Right now the high-yield average purchase price for a double-B or single-B index is about Treasurys plus 550, which is kind of analogous to what the triple-C spread was in 1995," a banker said. "It's about 13% yield to maturity for B2 or B3 collateral. That's a tremendous arbitrage."
Recent credit events, including defaulted syndicated loans that put Bank of America and First Union National Bank in the headlines last week (as creditors), has justified some concerns over the corporate credit story.
"A lot of people think it's a great time to be ramping up, but it really depends on what you think default rates are going to do in the future," said Fitch's Gordon.
"[The credit events] have had two impacts," said Moody's Gluck. "One is that clearly it has caused spreads to blow out, both defaults and downgrades. So the collateral is cheaper and the arbitrage is more attractive. At the same time, there's a reason that those spreads have moved out, and there's clearly some caution on the part of investors."
Another factor making it difficult to place equity is the sheer number of deals competing for the same investors. Further, the continued devaluation of the Euro is making it more expensive for European investors to partake in deals.
Sources estimate that European investors have historically made up at least 50% of the CDO equity investor base.
"What happens is that you have to move beyond the usual suspects," said Eileen Murphy, a managing director in the CDO group at Chase Securities. "And you also have to be very creative, and repackage what is CDO equity risk into a form where you can sell it to other risk takers."
For example, managers can add features such as principal protection via Treasury strips. Others might use derivatives to present risk exposure that a certain group of investors may be accustomed to taking, Murphy said.
Given the tempting collateral for CDO managers, those who decide not to launch deals in this market for equity reasons might be buying assets now for next year's deals, sources said.
"A lot of people are saying this is such a great time to be buying collateral, so I wouldn't be surprised if you see some people kind of very quietly start to pick up collateral, but not actually launching a deal until next year," Gordon said.
However, Gerard O'Connor, also in the CDO group at Chase, noted that there are balance-sheet issues associated with that strategy.
"You're artificially inflating your balance sheet for a transaction you're planning to launch in the first quarter, which doesn't accurately reflect what your balance sheet normally looks like," O'Connor said.
Some Done Deals
Meanwhile, several deals have closed in the last few weeks, including two brought by First Union: a $173 million deal called Capstan CBO, and a $485 million deal called Crest 2000-1.
Merrill Lynch placed the first ever CDO out of Portugal, called Tagus Global Bond Securitisation. The deal was worth EURO287.
Goldman, Sachs & Co. was underwriter on Centurion CDO II, a near $500 million cash flow deal managed by American Express Asset Management Group.
Goldman Sachs also brought Ares IV CLO to market. Ares CLO Mangement IV is collateral manager on the deal, which is worth approximately $500 million.
