With the increasing number of defaults that the market has seen over the last year, analysts say that the first-loss piece in older collateralized bond obligations have taken a direct hit, prompting market players to be more cautious with new deals coming to market.
The higher number of defaults is a greater concern for CBOs rather than collatarized loan obligations (CLOs) because bank loans have a higher recovery rate than bonds.
Though the high level of default can be a concern for CLOs, it does not necessarily impact a CLO's equity unless it relates to having lower recovery rates than what historically has been seen.
The key, CDO portfolio managers say, is credit selection- picking credits that have good asset coverage so that even if there is a default, the recovery from the debt can be complete. Good credit selection entails picking companies from industries that are performing well and choosing firms that have solid management. In addition, particularly in the bank loan market, credit selection also means picking deals with collateral protection.
"With a high recovery rate, your equity tranche will still have a chance to generate the modeled returns," said Jonathan Trutter, a managing director at Deerfield Capital Management. "It really is about picking the individual credits within any industry and spending the time with credit analysis."
Deerfield, for instance, has teams of analysts devoted to evaluating specific credits on the bank loan, high-grade and asset-backed areas.
Pro-active portfolio management seems to be the key, and has been a major consideration in terms of the rating of new CDO deals.
"We've certainly increased our focus on an asset managers' ability to identify problem credits early and make appropriate decisions on how to deal with problem credits," said David Howard, a managing director at Fitch.
However, the very same defaults that have caused trouble for older CBOs is the same thing that makes new deals more attractive. "Having a large spread between your funding costs, which are investment grade, and your assets, which are non-investment grade, makes new deals more attractive," said a rating agency analyst.
"But there are other factors that you have to look at," said Deerfield's Trutter. "If there have been historical defaults in the portfolio you would have a sense of how well that manager has been at avoiding defaults. If there has been a history of defaults, that would give you pause even if the piece was priced attractively in the secondary market."
