The European CDO market has been booming this year so far, particularly among those CDOs focused mainly on high yield bonds. Issuance year-to-date totals $2.3 billion - nearly the same amount as total issuance for the whole of 2000.

But all the activity in this normally quiet market could be short-lived. While European CDO issuance has been healthy over the past six months, the performance of European high yield bonds has not, making things difficult for those structuring CDOs. In fact, experts predict a move out of European high yield as CDO collateral, and into other asset classes as the year goes on.

The lack of high yield industrial supply over the past six months has led to a serious lack of sector diversification. Over half of the new issues in Europe's high yield market have been in the telecom sector and even a CDO that owned every single credit available would still find it difficult to meet the rating agencies' criteria for diversity. This has made it difficult for managers to find enough collateral for transactions with European high yield bonds as the core element

Initially, European CDO transactions included high yield bonds as a high proportion of the collateral pool. Morley Fund Management's Global High Yield Bond Trust, launched in early 2000, was backed 60% by European high yield bonds and 40% by US high yield bonds.

But even then, lack of collateral in the European market forced the manager to include U.S. high yield bonds in the CDO to achieve the diversification required to satisfy the criteria.

Deterioration

Even if there was adequate supply in Europe, the recent deterioration in European high yield bonds has resulted in around half of the market trading at distressed levels. Industrial names, in short supply, are trading at artificially high levels, so a manager looking to buy high yield bonds risks buying them above par, losing out some potential capital appreciation. Having to counter telecom names at discount levels is another issue, and the high probability of further defaults in the telecom sector intensifies the risk of this strategy.

As a result of this increased risk, three of four CDOs have already been downgraded this year, and only one has been upgraded.

The weakening bond environment has meant that "the underlying investor appetite for CDO with large bond components is currently extremely poor," said Sara Halbard, portfolio manager at Intermediate Capital Group.

As a result, many mangers are lowering the concentration of high yield bonds in their CDOs and are looking instead to alternative asset classes for diversification. Many managers are having to use a mixture of assets, including US high yield bonds, leveraged loans and investment grade bonds in addition to the European high yield bonds, said Stroma Finston, director, structured finance at Standard & Poors.

The most popular of these diversifiers is leveraged loans, which "considerably reduce volatility while offering greater stability to the portfolio," said Frank Ferrantelli, head of high yield sales, trading and research at CIBC World Markets.

Copernicus Euro CDO 1, recently launched by ING Capital Advisors, was backed by a portfolio of 75% leveraged loans and 25% high yield bonds. And another recent transaction, Duchess I CDO, a E750 million arbitrage CDO from Duke Street Capital Management, will invest at least 65% of its portfolio in senior secured loans, and a maximum of 20% in high yield bonds.

"The reason behind the high loan component stems from the fact that our team has most experience in the senior loans market," said Zak Summerscale, who is on the CDO team at Duke. "Further, in UK bankruptcy law, senior lenders are favored above subordinated debt, which in the current environment is a welcome protective measure," he said.

Recovery rates are also higher for loans and, given the high cost of a high yield bond now, investors want to rely more on secured bank debt. A CDO with a blended mix of bonds and loans as opposed to just bonds has a better overall recovery rate and can achieve a better credit status from the agencies. Such products are also being structured in the US now (see story, p.1).

Flexible managers needed

The blending of asset classes should allow CDO builders to overcome some of the problems they are currently facing. But because the European market is relatively young, it will be difficult to find managers with sufficient experience to run these mixed-asset CDOs. Indeed, sources say there is a dearth of people able to manage even the most straightforward CDOs, let alone the more complex ones.

The only answer seems to be increasing the number of managers on any given CDO.

"It's not unusual to find two fund managers involved in running a CDO - one that specializes in the bond side of the market and one on the loan side, thereby combining their experience and capabilities" said Ferrantelli.

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