As investors look to diversify their portfolios, more multi-sector collateralized bond obligations are expected to hit the market, said industry experts, aiming the spotlight on the more illiquid sectors.
"I think you could see transactions comprised of ABS, project finance loans, commercial mortgage-backed securities, mortgage-backed securities - really the full gamut of structured finance products that are out there," said Lori Evangel, managing director of the CBO group at MBIA-Ambac.
The significant amount of issuance of CBOs in 1999 has impacted the spreads and the prices of the underlying collateral, she said. This is why investors are looking for "juicier assets" and there is a focus on illiquid collateral. Moreover, market players are leaning toward doing multi-sector CBOs and CBOs of CBOs,' Evangel explained.
"It's really a trend toward a focus on the illiquid sectors of the market," Evangel added. "So you are really talking about triple-B and double-B tranches of the entire structured finance market that would be potential collateral pieces in a CBO done in this way."
Tapping lower-rated tranches in the structured finance sector has its advantages. One of them is the availability of arbitrage. "You will see people taking advantage of the arbitrage spreads that exist," she added.
Making use of the multi-sector CBO structure has its perks, too. "There are a lot more corellation issues in doing a CBO of CBOs than doing a CBO of multi-sector CBOs," Evangel noted. She also mentioned that, aside from having less corellation issues, having different types of collateral in the pool helps in terms of diversifying the portfolio.
From a Rating Agency's Perspective
In 1999, Moody's Investors Service rated two deals with a mixed portfolio consisting of asset-backed securities and high-yield bonds.
"Probably the most difficult part of it is making assumptions about correlations," said Jeremy Gluck, managing director at Moody's, "You have to make assumptions about correlations within a bucket say of asset-backed or CBO securities and then across each of those, as well as corellations with high-yield bonds."
Moody's came up with a set of corellations based on modeling they've done which allowed them to calculate what is called the diversity score'. "The diversity score is a key to coming up with a credit enhancement or the rating given the credit enhancement for a CBO," said Gluck. He also said that they had to make assumptions about recovery rates for any sort of structured instrument that differs somewhat from those for high-yield bonds.
Aside from being motivated by diversity in the loan portfolio, market players have flocked to doing these kinds of mixed pools because of the lack of attractive opportunities on the high-yield side.
"There isn't much juice right now in the high-yield market," Gluck said. "There is not that much arbitrage opportunity and there's very little new issuance and people are looking for other assets to securitize that have wider spreads on them."
The natural focus would be on structured instruments such as asset-backed securities, collateralized bond obligations and commercial real estate. "One could increase the arbitrage opportunity potentially within a high-yield deal by having some sort of structured basket," Gluck noted.
Consistent with this trend, Moody's is currently working on a number of deals with such mixed pools."We're working on a significant number of deals now in which the collateral pool consists either of CBOs or ABS or commercial mortgage-backed securities or a combination of those and high-yield bonds."
And Gluck expects this trend to continue "as long as the spreads are relatively wide on the structured instruments and somewhat narrower on the high-yield bonds."
