In response to continued downgrades in the 1998 and 1999 vintages, and the current economic slowdown, collateralized debt obligations in the past year have been coming out of the gate more cushioned and less leveraged, and often with structural enhancements that "apply the breaks" on deals showing trouble early on, industry sources said.
"The credit pendulum has clearly swung to a more conservative level," said David Tesher, a managing director in the CDO group at Standard & Poor's.
Today's CDOs, when compared to similarly structured deals in earlier cohorts, tend to launch with more subordination, and thus more maneuvering room for the collateral managers. Also, some deals include enhancements, such as triggers that divert excess spread for the purpose of buying more collateral.
"If it's true that there's more cushion, than the other trend I've heard is tighter restrictions on trading the portfolio, such as prohibitions on buying cheap par," said Douglas Lucas, head of CDO research at JPMorgan. "And if you combine higher subordination with prohibitions against abusive trading, than that's more significant than either alone."
All in all, what has changed most significantly, and allowed the added cushion, is the risk-adjusted return profile on the equity. What has historically killed the equity on earlier deals was overly aggressive recovery and defaults assumptions. In the 1997-1998 vintages, equity investors were promised internal rate of returns in the mid-30's, while today's investors are generally looking at figures in the high teens to low-20's.
"Experienced CDO equity buyers are much more realistic in their expectations about what a good risk adjusted equity return is," said a bank analyst. "They know that it's unreasonable to expect returns exceeding 25%, because this forces CDO managers to delve too far down the credit spectrum, resulting in a very brittle and volatile return profile."
"Today the managers have been able to sell a different equity return profile, that effectively takes into historical collateral performance trends and the current macroeconomic environment," S&P's Tesher said.
Still lucrative
Perhaps more realistically drawn, equity returns are still considered lucrative. Even with less leverage, deals are benefiting from the healthy spreads in the collateral markets (high yield).
However, at least a few market observers think managers are currently overcompensating, and that leverage will come back as time goes by, particularly in an improving economic environment. Essentially, whether or not current levels are overcompensated will depend on where we are in the credit cycle.
"If you think that we are currently in a recession, and that we are eminently coming out of it, maybe this is overcompensation," S&P's Tesher said. "If you feel we are not at the bottom as of yet, that might not be true. It all depends on where in the trough you think we are."
Still, in economic uncertainty, spreads on corporates tend to be wider, which allows for more cushion in the deals. If the collateral is really more volatile, then the deal will benefit from the extra cushion.
