While leveraged loans have proven more stable and less risky CDO collateral than high yield bonds, some might be questioning their presence in structured vehicles, as ultimate recovery rates on bank loans are declining.

Actually, bank loan ultimate recovery rates have been falling since 1996, and for the extremely stressful period from 1998 to 2002, stood at 74.1%, according to David Keisman, managing director, (risk solutions) at Standard & Poor's. Keisman spoke at Bear Stearns' 12th Annual Global Credit Conference last week.

While this is still substantially higher than the 45.8% rate for senior secured notes, it is still something that should be taken into consideration. Thus far, though, analysts have been unable to figure out why rates are declining.

"We asked ourselves whether bank debt structure has changed since 1998 and found that a declining trend in the structural quality of bank debt does not appear to be the reason for lower ultimate recovery rates," Keisman said. "Actually, we don't know yet why they are declining, although we are working hard to find out."

Although worsening structural quality is definitely a factor in declining senior unsecured bond recovery, collateral and the extent of the debt cushion play an important role in determining the ultimate recovery rates for bank loans, Keisman said. Bank debt with a debt cushion of 50% or more, and collateralized by all assets, had much higher ultimate recovery rate than all other bank debt.

Furthermore, trading prices usually underestimate the nominal ultimate recovery rate of both bank loans and many bonds, while initial trading prices for defaulted debt do not seem to differentiate based on the quality of an instrument's structure. In light of this scenario, and given that better-structured loans have a much higher recovery rate, these loans are smarter trading bets, Keisman said.

But a manager running a leveraged loan CDO still has comparatively less to worry about, since leveraged-loan CDOs have historically experienced greater rating stability than other CDO structures, particularly high yield bond CDOs. While the latter have suffered 1,087 downgrades year-to-date, only 89 high yield loan CDOs have thus far been downgraded, according to Bear Stearns' CDO research.

Investor appetite for leveraged-loan CDOs is still high - and this year, too, should see both robust issuance and strong performance, said Jean Fleischhacker, senior managing director at Bear Stearns. Leveraged-loan CDOs represented 11% of new CDO volume for the first quarter of 2003, out of a total $16 billion.

And certainly, there is no dearth of loans for collateral: In each of the past five years, leveraged-loan issuance has exceeded $200 billion.

In Europe, too, leveraged loans are the top choice for CDO collateral. Standard & Poor's is the latest agency to release a report extolling the virtues of leveraged loan-backed CDOs there. According to the rating agency's European structured-finance ratings group and Standard & Poor's LCD, leveraged loan-backed CDOs continue to show good performance as compared with other structured vehicles.

S&P first assigned ratings to a CDO backed by leveraged loans in 2000 (Blue Eagle CDO S.A. and Concerto II B.V.). Since then, the number of new leveraged loan-backed CDOs closing each year has steadily increased, and 10 are expected to close by the end of this year, according to S&P. To date, S&P has assigned ratings to 15 CDOs backed by leveraged loans in Europe.


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