Investment-grade average CDOs showed a significant increase in volume in 2000 compared to 1999 - to the tune of 450% - and 2001 is expected to be a strong year as well, according to panelists at last week's 2001: A CDO Event.
With the current flight to quality, Salomon Smith Barney is projecting volume to top $11 billion this year, compared to $5.6 billion in 2000. Salomon brought to market Travelers Funding Ltd, the first investment-grade average deal, in 1998.
"In an environment where [Moody's Investors Service] is projecting the average default rate in the high-yield market to exceed 9% by year's end, some investors have become more defensive when viewing CDO's as an asset class," said Glen McDermott, head of structured bond research and strategy at Salomon.
Bankers are confirming the bid for these types of deals.
"Right now triple-B average rated deals can be structured with a 19% equity return, which is enough to get these done," one of them said during a session at last week's conference. "Once you sell the equity your deal is basically done. Nevertheless, the upper 90% of an investment grade CDO, which is triple-A, is an easy sell to investors who want diversification from their high-yield CDO exposure."
However, there's a camp of investors who remain skeptical of these deals. The opposing argument is that subordinates are too leveraged, because the lower yielding investment grade assets will only allow for an equity piece that accounts for 4% of the deal, as opposed to arbitrage high-yield deals that typically have equity accounting for 10%-12% of the deal.
So while the credit is better in investment-grade deals, the subordination cushion is smaller. Because of this, the triple-B's tend to trade wider on the investment-grade deals, while the triple-A's trade in line with their high-yield brethren.
Because the deals are more leveraged than the typical high-yield CDO, they can be more susceptible to event risk, in cases where the manager is exposed to large positions. Small position sizes protect investors from fallen angels, or highly-rated names that experience significant credit deterioration in a short period of time. Examples of fallen angels in the past year include names like Xerox, the California utilities, Crown Cork & Seal, Finova and Owens Corning. Event risk, by its nature, is unpredictable.
"The key to these deals is that the manager has to manage to at least 80 to 120 positions or more," McDermott said. "Obligor diversity is key. There needs to maintain very small, bite-size positions."
According to one panelist, another problem with the investment-grade corporate deals is that there's only so much diversification in assets that can generate the yield required for the arbitrage.
Investment grade debt backed deals are likely to include esoteric concentrations, such as project finance bonds, enhanced equipment trust certificates, REITs, and emerging market assets, with baskets for crossover credits.
One speaker argued that because of this high concentration of esoteric assets required to meet the diversity scores, substandard managers of investment grade CDOs might be inclined to buy assets which they do not have an expertise in.
The deals are typically structured so that 70% of the assets are in the triple-B, triple-B-minus range, while the remaining 30% are rated no lower than double-B-minus.
Although the deal structure is sometimes called a barbell, it's not the typical triple-A/single-B barbell, but rather only balanced over one ratings dispersion, triple-B/double-B.
