As deteriorating market conditions continue to punish collateralized bond obligations of the 1997 and 1998 vintages, savvy players are developing coordinated high-yield bond workouts addressing the unique constraints of CBOs.
N.Y.-based CDO boutique Triton Partners, with $1.4 billion under management in four high-yield CBOs, is taking steps to resist the impact of the negative credit trends and improve recoveries for its own and other managed CBOs. Triton has set up a dedicated restructuring effort, Triton Partners Restructuring LLC, led by Daniel Arbess, one of Triton's founding partners and a former debt restructuring attorney at White & Case. The company's goal is to organize other high-yield CBO bondholders and serve as an agent in restructuring negotiations to maximize economic recovery in a form suitable to CBO structural constraints.
Nevertheless, analysts' note that high-yield bond workouts are fairly uncommon compared to workouts of leveraged loans, emerging market sovereigns, and emerging market corporates. Meanwhile, according to Standard & Poor's, as of the first quarter 2001, CDOs held 13% of all US high-yield bonds.
High-yield CBOs issued in the past few years are struggling to perform in a default and recovery environment far less favorable than anticipated when the structures were formed, explains Triton's Arbess. Return expectations for most structures formed between 1997 and 1999 were generally based on assumed annual defaults of two percent with recoveries of one percent, yielding annual "par losses" of 1%, which is in line with historical averages. By contrast, present market defaults are approaching 10%, and recoveries have sunk below 25.7% (dragged down by the horrific telecom recoveries at 12%), according to Moody's research.
While newer CDOs have the benefit of wider excess spreads (and therefore more margin for par losses), the high default/low recovery cocktail is taking a heavy toll on CDO structures originally designed to absorb mid-1990s levels of credit-related losses, especially those of the 1997-1999 vintages, said Arbess.
The main benefit of a coordinated workout is higher recoveries within the context of a CBO's stated constraints says CDO analyst, Eric Banks of Bear Stearns. "Individually, any one CBO would not have a large enough holding to drive a negotiation," Banks said. "As a union, several CBO managers may own a large percentage of a particular issuer's debt, and thus have greater input toward a restructuring."
As Arbess explains, the diversity of interests and lack of leadership among high-yield CDO managers have recently been exploited by equity sponsors, senior lenders, and issuers. As a result of a lack of cohesion among the CBO manager's holding defaulted credits, attempts to impose restructurings on terms potentially disadvantageous to the managers and depressed price levels have been seen. In such cases, the lack of organized and timely intervention on behalf of CDO investors has resulted in diminished bondholders' value and lower potential recoveries, he added.
In addition to promoting higher recoveries, Triton hopes that its initiative will advance recovery solutions that work within common CBO restrictions. For example, because CBOs must service debt obligations, these funds function best owning current cash-pay securities. Consequently, CBO indentures typically have provisions that may limit the economic value of holding defaulted bonds or non-cash pay securities, such as equity, preferred stock or PIK-able debt securities that may derive from a restructuring.
Also, equity or non-cash paying debt securities received in a restructuring often must be sold, under the rules of most CBO indentures, after a limited holding period, and they are given low or no value for CBO over-collateralization tests.
For these reasons, CBOs favor cash paying debt securities in a restructuring and not conversion into equity. "The key here is that by bringing together the CBO managers and the respective high-yield bond issuers, collectively, a faster workout may be accomplished that would help solve the negative carry problem associated with CBOs holding defaulted securities," adds Bear Stearn's Banks.