In the next few months, possibly this quarter, the first collateralized bond obligation in more than a decade to be backed entirely by distressed debt will hit the market, analysts and traders said. There have been several similar proposals for such deals to hit rating agency desks in recent months, and there is a good chance at least one will be approved by analysts before year-end.

Strangely enough, a wholly distressed-debt deal marks a return to the CBO market's distant past, as the last fully distressed-debt deal was issued in 1988 by Mellon Bank. It is still unknown who will issue the 2000 edition of the deal, but analysts predicted it would likely be a money manager focused on distressed debt or, like Mellon, a bank saddled with a raft of underperforming loans.

The concept of securitizing distressed loans via a CBO or collateralized debt obligation is not unknown to market participants, as the average CBO in 2000 usually features a tranche backed by underperforming loans as a lure for investors interested in greater yield and risk levels. It is only natural that the next step would be to excise the top-rated classes, and offer a greater overall measure of risk to investors via a pure distressed debt deal.

As little as two years ago, however, such a strategy would likely have backfired, one trader said. He noted at that time the CBO market was still perceived as a strange outgrowth of the asset-backed securities market and that the average investor would have been turned off further by throwing deals backed by "damaged goods" into the mix, he said.

That situation has greatly changed. Because CBOs have claimed the spotlight in such areas as high-yield corporate bonds and ABS in recent years, and have been included by several major bond market indices, the average investor has begun to consider acquiring CBOs essential to maintaining their overall debt performance.

The shift is apparent in the sector's solid new issuance rates. Fitch projects up to $55 billion in new deals in the sector for this quarter. There were roughly $60 billion in new CBOs issued during the first nine months of 2000, and the proposed fourth-quarter new issuance totals would bring 2000's CBO market issuance to roughly $115 billion, up 15% from 1999's record of $100 billion.

"Business is booming," said Robert Grossman, group managing director of loan products for Fitch. "We're seeing CBOs and CLOs being used more as a corporate finance tool, as a mechanism to manage risk."

With many issuers concerned about rising default rates of investment-grade and high-yield corporate debt, securitizing that risk via CBOs becomes very enticing. Again, Mellon leads the way. By removing $1.2 billion of distressed loans via its 1988 deal, Mellon managed to take much of its bad paper off its books before the recession of the early 1990s began, thus sparing the bank from some of the worst effects of that period.

Fitch's Grossman said that an issuer willing to assemble a pure distressed deal should be prepared to face even stricter scrutiny from rating agencies and that the deal will need a number of clear-cut mechanisms to reduce risk. "The biggest issue would be the timing of cashflows," he said. "There needs to be a timeline [for payment to investors] and some sort of liquidity mechanism to make sure that happens."

Should the distressed deal succeed in the market, it could spark a revival in CBOs backed by high-yield debt. So far this year, high-yield CBOs have been losing ground to deals backed by high-rated securities, with about 25% of the CBO market consisting of structures backed by ABS and mortgage-backed securities.

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