Currently in the European market with a $250 million to $350 million collateralized bond obligation called TCW Euro GEM I, the emerging markets/fixed-income group at Trust Company of the West continues establishing itself as a benchmark CBO asset management group.

Case in point: the TCW GEM II senior notes, which, like the Euro GEM I notes, are backed by emerging markets debt, were upgraded to their 1997 issue-date ratings last month, a truly unique event considering the drop in credit rating of emerging market debt since that time, according to sources at the ratings agencies.

The Euro GEM I transaction, which is expected to price in May, is one of the first Euro-denominated CBOs, said Nathan Sandler, a managing director and portfolio manager at TCW.

"The emerging market [component] is providing a lot of the strong attributes to the structure of the fund," Sandler said. "It's obviously providing yield and capital appreciation, but it's also providing global diversity and average rating."

The final capital structure is to be determined, though TCW anticipates three classes of rated debt: a triple-A piece, a single-A piece and a triple-B piece. Both Moody's Investors Service and Standard & Poor's Ratings Services will be rating the transaction. The most senior tranches will likely be floating-rate, Sandler said.

As for insurance/credit enhancement, "We haven't made that final determination," Sandler said. "It will be based on how we can get the best execution."

Proactive Fund Management

The upgrade of the GEM II notes, which was announced by Moody's on March 16, is unique because much of the "investable" universe in the emerging markets has been significantly downgraded over the last couple of years.

"GEM II was basically issued at peak valuations right at the inception of the Asian crisis," Sandler explained. "And everything that unfolded from there on really posed a direct challenge to the success of that fund."

Despite that fact, TCW was able to construct a viable portfolio strategy to restore the original ratings over the senior and mezzanine notes, without compromising any of the classes represented in the capital structure, Sandler said.

"That was really the single criterion we used in determining whether, ultimately, we wanted to go forward with something like this," he added.

The buys and sells - to adjust the underlying portfolio - amounted to between $150 million and $160 million.

"It really takes a tremendous amount of activism, or proactive management, to manage a CBO where the underlying market has undergone the tumultuous changes that ours has over the last two to three years," Sandler said.

In addition to rearranging the assets under management, the TCW sought consent and solicitations to amend the indentures, to provide more flexibility in managing the portfolio in crisis.

At inception, the TCW GEM II was structured primarily to invest in emerging market corporate bonds. Currently the concentration is about 60% emerging market corporate debt, and 40% emerging market sovereign debt.

The GEM II fund has suffered no credit losses from defaults, nor any cash flow interruptions.

"There are any number of things that could have gone wrong along the way, but I think that the steps that we took to manage risk and to stabilize the underlying position of the portfolio proved to be the right things," Sandler added.

"The upgrade itself was just one more step towards positioning the fund on stronger footing, so that when everything was said and done, we delivered to our investors the total returns that we expected at inception," he said.

Underlying Assets

One of the most important factors in successfully managing a CBO is understanding the relationship of the investment vehicles to the underlying market.

"I think where we've really established our credentials is in being able to directly apply the expertise we have in this asset class to the expertise that's required to manage these very complex investment vehicles," Sandler said.

However, just understanding the market is not sufficient for succeeding in CBOs, Sandler explained. "You need to recognize the unique challenges that are posed in managing CBOs and CDOs, and those challenges are several fold."

Delivering the intended returns to all of the investors, managing the various interests of the capital structure and minimizing the credit losses are among these challenges.

"All of these things require an enormous amount of time and an infrastructure of professionals who understand both the market and the unique challenge of the investment products," he said.

TCW

Including GEM II, Sandler's group at TCW has issued four emerging markets CBOs since 1996, with $1.4 billion in assets under management. In the four CBOs the annualized distributions to equity holders have ranged from 10% to just over 20%.

The four funds have exposure to markets in nearly 40 different countries, and over 50 separate companies.

"What we're trying to do at any given moment is identify the most unique opportunities available across the full investor universe of our asset class," Sandler said.

"We're always looking for ways to use the raw material of emerging market cash flows that we can slice and dice to deliver the most attractive risk-adjusted returns to the widest range of investors."

TCW markets to both investment-grade and below investment-grade investors.

Apart from Sandler's fixed-income and emerging markets group, TCW is involved in the CBO business in other markets. The major asset classes represented are U.S. and European leveraged finance, including high-yield and mezzanine and mortgage-backed securities. -

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