The market-value CDO, a structure that had virtually disappeared from sight in the European financial marketplace over recent years, has reappeared. Sources say that these vehicles, which now come equipped with a range of new attributes they did not have in the past, are greatly in demand from an eager investor base, and going forward, issuance is expected to pick up.
Market value CDOs - which differ from their par-based, cashflow counterparts in that their value is linked to the market value of a diversified pool of underlying assets - went out of style in the late 1990s after severe price volatility in the credit markets put undue pressure on many structures. Hard-pressed to find the necessary equity to keep structures afloat, managers of market value CDOs had no choice but to liquidate holdings, and so until 2004, these kinds of vehicles were not popular at all.
Now, though, market value CDOs and market value CLOs are once again finding their place among Europe's wide array of investment offerings, particularly since spreads are so tight and investors are looking everywhere for returns.
Unlike their counterparts of the late 1990s, today's market value CDOs are being designed to better weather temporary market disruptions, said Fiona Taylor, an associate director at Fitch Ratings in London. They feature revolving facilities, for instance, so that a manager can get increased flexibility in leverage and have the ability to issue debt during tough times. These enhancements add to their appeal, Taylor said, and make them more attractive for even a potential downturn in the market.
Also, market value CDOs and CLOs are using such asset classes as high-yield bonds, leveraged loans and mezzanine debt for collateral, something that was not the case in the late 1990s. These kinds of asset classes are probably more attractive right now because the arbitrage opportunities in high-yield products may potentially be more easily realized in a market value structure's active trading book rather than under the predominantly buy-and-hold cashflow framework, Taylor said. Also, European loans - both senior and mezzanine - have thus far been very stable from a pricing perspective.
However, there is no saying that leveraged assets will be the only form of collateral used in market value CDOs because there has been some talk of the potential for high grade asset-backed securities to be used, too, Taylor said. "I expect that other asset classes will follow investor demand," she said.
The newfound interest in market value structures in Europe is largely due to increased liquidity in the European leveraged loan market, said Kevin De Baere, associate director at Standard & Poor's in London. Over the past 12 months, the European leveraged loan market has changed considerably, with institutional carve-outs in loan deals increasing, he said.
"In order to structure a market value CLO, you have to have a liquid asset base from which to choose assets from," De Baere said. "Even though we do not observe liquidity levels as high as in the U.S. market, secondary trading in European loans has increased substantially as a result of more active participation in the loan market from a greater number of institutional investors. The liquidity in the underlying loan assets has allowed for market value CLOs to once again gain ground."
But while high-yield bonds and leveraged loans might have a good track record, and even as the market value structures of today are better equipped than their predecessors to withstand market volatility, there are some who doubt the tenacity of these instruments at a time when a malaise is starting to creep into the credit markets, and as there is talk about an increase in defaults.
"The list of names to keep a watch on, of loans that are trading in the low to upper 90s, has grown and is just going to keep on growing," a CLO manager said. "There may not be anything fundamentally wrong with many credits, but because of the general level of discomfort that has set in, people are going to be selling simply because of that, and prices are therefore going to be low from a purely technical perspective."
In light of this, market value CDO managers might be forced to sell their assets just because of the technicals of the market, he said, and as such, "the market value of the underlying assets will become disconnected from their real value, and running such structures could prove tough."
All the same, there is certainly an interest in market value CDOs at this time, particularly since in today's marketplace, cashflow CDOs may not be able to offer the high returns that investors are looking for.
"We have had several queries about these structures and are currently developing criteria to rate them," Taylor said. "There is a lot of interest in the market and people are even investigating the possibility to add market value aspects to normal, cashflow CDOs by adding, for example, a tranche that is market value in approach to an existing CDO."
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