Volatility in global markets this year has provided ideal conditions for European collateralized bond obligation (CBO) buyers.
Five new funds were set up in 2000 and up to eight more are expected to debut in 2001. But while there is huge technical demand, the lack of depth to the collateral pool is still presenting CBO buyers with problems.
With many high-yield bonds capable of dropping 10 points overnight, there would seem to be no shortage of potential investments for CBO buyers. However, many of these issues are ineligible for inclusion in their portfolios. Despite an increase in industrial issuance the European market is still mired in telecom, media and cable supply. Of this, around half is rated single-B or below.
In recent weeks, the troubles besetting telecom issuers have spilled over into the industrial sector. With profit warnings becoming increasingly common in all areas of the market, CBO buyers are having to focus more on the dwindling number of higher quality names and be extremely selective with the rest. Many have started to look beyond the high-yield bond market to achieve variety.
The lack of diversification in the fledgling European market has always been a thorn in the side of the CBO funds.
"In the U.S., CBOs emerged as a by-product of a very large and diversified market. In Europe, the reverse is true with investment banks using CBOs almost as a support feature for the market, which is still at an early stage of development," said Sara Halbard, portfolio manager, Intermediate Capital Managers Limited. "As a result, managers run the risk of being forced to buy assets to fit the structure".
While some see this as a threat to the development of a healthy European market, others see it as a necessary evil. "The development of the CBO market in Europe has to date been driven by investment banks, a trend which is likely to continue until it becomes a diversification argument for investors," said David Keen, investment funds director, Morley Fund Management. "More stable conditions should allow this diversification benefit to develop."
Whether conditions stabilize or not, CBO fund managers are unanimous that new vehicles will come into being. While they welcome the idea of having more familiar names in the market, many have reservations about the lack of experience among the less established prospectors. "There will certainly be more funds set up," said Halbard, "But it is our view that there are still relatively few players with the combination of expertise and access to a number of different asset classes needed to put these deals together."
ICG already has two funds in the market, Eurocredit CDO1 BV and Eurocredit CDO 11 BV. Those with less experience to draw on are looking to the more mature US market for inspiration. U.K.-based private equity firm Duke Street Capital is planning to use the proceeds of a high-yield bond to set up a CDO fund, a strategy that is common among U.S. private equity houses but new to Europe.
New funds will also be welcomed to market by the rapidly broadening investor base. Insurance companies have hitherto dominated the European CDO market, but fund managers report an increasing amount of retail money being put to work in the sector. Pension funds are also taking a more prominent position in the CDO market. "We see the European market broadening in both high yield and investment grade CBO style products," Keen said. "There is likely to be greater participation in loans due to the lack of diversity in the European bond market albeit with a heavy initial reliance on the U.S. market for collateral."
While the continued widening of asset spreads should ensure that demand for CBO-style issues continues to grow, there are fears that it is also frightening away potential investors. But CBO buying is based on a view the long-term. Many of these funds are buy-and-hold, and expect to sustain losses in difficult times. The rewards, however, may well be worth the extreme risk in the long run, particularly when the opportunities for risk reward are becoming increasingly limited.
