Investors will continue to be cautious in Europe's CDO land this year. The credit deterioration that defined the first half of 2003 and the tightening collateral spreads that limited issuance for the second half of the year have produced a slightly more conservative approach to market dynamics.
"Overall the year was relatively positive for the market with a number of deals executed despite market dynamics; but we didn't get the volumes nor structures that were hoped for, and the credit and spread environment put volumes a bit off," said one market source. "I think that people are looking to this
year to seek out better arbitrage opportunities."
So far, the year has kicked off with tighter spreads in secondary trading. According to JPMorgan Securities research, ABS and CDOs look ready to move tighter to reflect the improving economic environment and existing market technicals. Demand seems to be outpacing supply. This, combined with a historically wide pickup to fixed- income alternatives, should spur some issuance.
"In this context, we believe that benchmark ABS spreads (UK RMBS, credit cards) will move tighter but sectors that offer incremental spread pickup will outperform (non-conforming RMBS, CMBS, CDOs)," reported bank analysts.
This tighter spread environment experienced last year sparked interest in CDOs of ABS and CDOs of CDOs. By August 2003, the majority of new issues circulating in the pipeline were those backed by ABS and leveraged loans, largely attributed to the products' yield-enhancing spread and stability, said market sources. A number of these deals were executed through the private market and generally incorporated customized CDOs as the underlying ABS.
These customized CDOs are pure mezzanine synthetic transactions that take the form of credit default swaps. Reaching a sufficient level of diversification can sometimes be a problem when putting a portfolio in place, but creating diversified exposure for a synthetic static deal can happen in 24 hours.
"On both the cash and synthetic side, we saw more mortgage-related deals being done and with interest rates being so low, this trend will continue into the New Year," said one market source. "You'll continue to see more of what was done in 2003 continued into the near term, at least. I think the market expected more activity from CDOs of CDOs with only half of the volume predicted actually getting done last year. We expect to see the rest along with new transactions emerge this year."
While innovation is unlikely to be curbed this year, investors are still shying away from deals with longer execution times and more complicated stories. "People want to do deals they are sure will get done quickly, and some of the transactions we were hoping for at the beginning of 2003 are still limited by longer execution times and might not find the needed investor appetite," said one source.
Collateralized Fund Obligations were enthusiastically touted at the beginning of 2003, and while a few squeezed onto the scene, the expected volume has been tainted by the relatively longer execution, as well as relatively a new ratings approach for these products. The market still hopes to see more of these deals in 2004. The European investor base is growing and market transparency is improving, which should lead more investors into this asset class.
"The problem is that these deals depend heavily on management," said one source. "The mantra right now is looking at asset classes where you can use your existing CDO technology. If you're experienced with CFOs, then it makes sense to continue to explore them into the New Year."
Kitchen-sink transactions such as the Jazz CDO may also generate more appeal because of the wider variety of assets provided to buyers. These transactions combine cash flow and synthetic CDO technologies under one transaction roof. These present, of course, more challenges in execution because of the larger variety of assets, which means the collateral management firm needs to possess a wide range of experience.
Emerging-market CDOs were also promising in early 2003, but fell short of expectations as arbitrage disappeared in the sector. Several were expected to price during the year.
"The credit environment and regulatory environment makes for a less sexy story in 2004, but overall I think people are looking more positively at the market this year," said one industry source.