Collateralized debt obligations continue to flood the market. So far there's been $30 billion in funded CDOs globally, compared to $26 billion at this time last year, according to Douglas Lucas of J.P. Morgan Chase.
Standard & Poor's has told investors that it has 50 CDOs in the pipeline to rate by the end of June.
What is amazing to some players, however, is that the new issues market continues to thrive despite a relentless jumble of downgrades and credit events headlining the sector.
"I think the market has come to accept the downgrades in this product," said Dorothy Poli, who runs Scotia Bank's Liberty Street Funding conduit, an investor in triple-A CDO paper. "But also, the spreads on CDOs are wider than in some other classes, so it's still very attractive. I think people are willing to take the risk because they're getting compensated in return."
As seen in recent deals, a triple-A tranche of a high-yield bond CDO tends to price in the mid-40s to 50s over Libor range, while the double-A's and single-A's jump to the low-to-mid 100s. Spreads on triple-A credit cards are pricing in low teens to 20 over Libor.
Poli also pointed out that the CDO downgrades are primarily occurring in the subordinate tranches, and only a small handful of triple-A bonds are known to have been nicked. Those include Stellar Funding, Bistro (as well as Eisberg Finance), and ML CBO XVIII.
Vintage '98
So far this year, Moody's Investors Service has downgraded (in most cases, multiple series of) approximately 21 different deals, compared to 25 for all of 2000. S&P, which has historically only rated the more senior tranches, has knocked ratings on at least six deals this year, compared to nine total for 2000. Fitch has downgraded eight deals so far this year, compared to nine deals total last year.
As Moody's discussed in its recent CDO rating transition study, balance-sheet investment-grade CDOs account for a substantial chunk of this year's downgrades (50%), in large attributable to two uncorrelated events, namely asbestos litigation and credit deterioration of the California utilities. According to Moody's, "Only during 1986 and 1989 were there as many investment-grade defaulters."
The bulk of the remaining downgraded deals this year have been cashflow, backed by high-yield or "speculative-grade" credits, from the 1997/1998 vintage - not a good time in the high-yield market.
According to Moody's, the frequency of downgrades in the 1996/1997 vintage is lower than in the 1997/1998, despite the fact that the former deals have been outstanding for a longer period of time.
Another perspective, however, is that in 1998, "everybody and their brother" jumped on the CDO bandwagon, not always having the expertise sufficient to manage the deals.
"Whether [these downgrades] are because there was a complete frenzy going on, where people were bringing anything they could to the market, or whether it was just some bad credit selection or bad judgement, you be the judge of that," said Steve Tompson, a managing director at Prudential Investments. "Nonetheless, you're finding a number of deals that are falling over on their sides, and in many cases these were done by managers who are not in the market any longer."
However, there are examples of managers with less-than-perfect track records that have been able to return to market. Currently, Alliance Capital Management, Pacific Life, and Highland Capital Management have deals in the pipeline, some of which are either watch-listed or downgraded despite some ratings volatility.
"Perhaps, if you are big enough, and you have a big enough track record, you are going to be able to withstand a nick here and there because nobody's perfect," Prudential's Tompson said.
As one source pointed out, it is important to compare managers to the market.
"A manager who loses 10% of your money may not be bad if the other managers lost 15%," the source said. "If you have a manager who came out with a deal in December of 1997, you may be more willing to look at him again."
Investor attitude
Even though the downgrades of certain vintages of CDOs can be explained away, the asset class has been received differently by investors than have other sectors suffering similar headline risk.
For example, the franchise loan-backed sector has all but shut down this year, following a few notable credit events.
One angle, from a discussion with CDO analysts at Fitch, is that the investor attitude in CDOs is different the attitude for vanilla ABS, even if it's the same investor.
The idea is that historically in ABS, issuers are borrowers using the market for balance sheet funding, whereby the traditional ABS investor is a lender.
On the other hand, the CDO sub-tranche or equity investor is often an investor looking for, or willing to take a specific, leveraged exposure to a particular risk, such as the high-yield or emerging market, at a given point in time.
Moreover, public ABS is not always spread/arbitrage driven, but often for funding or regulatory purposes. These ABS issuers have a vested interest in making sure their deals perform, so that they continue to have access to the market. In many cases, ABS issuers have even stepped in to support their transactions.
CDO balance-sheet deals, such as the CLOs done by banks, are generally structured to displace, or sell off credit risk, as opposed to funding.
"It's nice to have a servicer backing a deal," one analyst commented. "A bank laying off credit risk, via a balance-sheet CLO, is not going to step in and save the deal. They did the deal to get rid of credit risk."
