As investment houses ramp up their efforts in the collateralized debt obligation (CDO) sector, a move towards inclusion of alternative asset types in collateralized bond obligation (CBO) and collateralized loan obligation (CLO) issuance is paving the way for a strong CDO showing for the year 2000, market participants say.
Not only do multi-sector CDOs present excellent arbitrage opportunities due to higher yielding coupons, but this type of security is usually not subject to the market volatility inherent in emerging markets or high yield paper.
"I definitely expect CDO issuance to increase next year," said Bryan Gordon, an analyst at Duff & Phelps Credit Rating Co., "especially because the movement toward including these other assets is sort of widening the base of essential assets to be CBO'd'.
"It has thrown open the floodgates and there are a lot of things that people didn't think to be a securitizable asset in the past, which is now coming to the fore."
Indeed, the CBO "technology" is being used more often, Gordon says, and there is bound to be more of it in the future. According to Moody's Investors Service, CDO issuance totaled $90 billion in 1998, up from about $18 billion in 1996. This year, issuance is slightly higher than $90 billion, and analysts say that it will continue to grow next year.
"I would expect the [CDO] market to grow by at least 10% next year," Gordon said.
"There really hasn't been any major hiccups in the deals by and large last year," added Mike Mancini, an analyst at Fitch IBCA. "We were very busy all year long, and I think CBO/CLO issuance will naturally grow next year."
A Great Arbitrage
Investment banks such as PaineWebber Inc. have recently grown their CDO businesses in order to take advantage of what is currently considered a hot market.
Though issuance in market-value CBOs - the structures that typically have the most diverse asset classes - had dropped off this year relative to the volatility the market experienced in the autumn, credit spreads for cashflow up-front deals have "generally been perfect," Mancini said, and there has been no slowdown even with Y2K concerns.
"In a cashflow deal, as long as the individual bonds pay off and it doesn't default, then you are realizing a pretty rich arbitrage," he added. "You're buying at a discount and getting a 10% or 11% coupon, and it is not subject to market volatility unless you have to sell an asset because it is not performing or if there is a credit concern. That arbitrage is just very good right now."
Moreover, activity has also picked up because now CBOs can be 100% ABS, as opposed to previous years, when cashflow CBOs would allow only a 5% bucket for structured finance.
"There is a belief in the marketplace that ABS deals don't default as often as corporates do," Duff's Gordon said. "An equivalently rated ABS deal has a lower likelihood of default than a corporate does, at least that is the general consensus prevalent in the marketplace."
Therefore, a CBO of asset-backed securities is more likely to have a stable ratings prospective than one which is all high yield debt, for instance.
Typically, CBOs are comprised of high yield bonds, bank loans or a combination of the two, and occasionally private equity. According to Mancini, these types of CBOs have almost become "commoditized products" in certain shops that have solid cashflows and process deal after deal.
Still Some Doubts Left
Despite the lofty predictions for the CDO market, both lingering market volatility and growing credit deterioration still cast a shadow over any rosy projections.
"Several asset pools backing CBO/CLO issues have experienced significant deterioration in credit quality and asset value," said David Tesher, an analyst at Standard & Poor's Ratings Service. "Higher than expected instances of rating downgrades and actual defaults of underlying bond and loan assets have left investors facing a lower likelihood of ultimate principal repayment and, in some cases, lower interest cashflow coverage."
Despite this factor, Tesher maintains that CBO ratings are quite stable overall. According to his recent report, only three issues have been downgraded since 1995, when the CDO market first began its resurgence.
However, concerns about the market and the after-effects of last year's Asian crisis still exist in the minds of some dealers.
"Recent performance trends in the global CBO/CLO market demonstrate that these securities, like other structured financings such as asset and mortgage-backed securities, are not immune from post-issuance ratings volatility," Tesher added.
