September, the hallmark homestretch, is underway and the forces of the CDO market gather together in two weeks for the Bond Market Association's CDO Committee Conference. Considering how these instruments once perched on the brink of disaster, thanks to skyrocketing downgrades, there is no shortage of topics up for discussion.
Customized CDO vehicles and correlation trading desks reportedly received larger capital commitments this year, and the secondary market saw its first sizeable chunk of trading activity. With downgrades levels petering out in the first quarter, and stronger economic indicators emerging, the structured finance market looks to the Sept. 23 meeting to create definitive answers. How has this year's CDO harvest fared? How far has the credit cycle churned? How much should be allocated for collateralized debt obligations in 2004?
At least one featured guest speaker believes the current market is the right time to capitalize on these events. Sunita Ganapati, senior vice president and head of structured credit strategies for Lehman Brothers, spoke exclusively to ASR about CDO market nuances in 2003. During her conference appearance, Ganapati expects to address the significant movement of most credit cycle indicators and how CDO valuations are poised to see continued improvement.
"You want to be in secondary distressed CDOs and you want to be in synthetic customized tranches, where you design what kind of risk you want to take. Those are the two areas of primary interest since the beginning of the year," said Ganapati.
Although synthetic issuance is slightly slower, technicals in the synthetic market are making it attractive to purchase equity tranches, Ganapati noted. Many correlation desks are long equity-risk, "so they're willing to offer it out cheap, even though the arbitrage in issuing such a tranche is somewhat weak. It actually makes sense to look at all the tranches," she said.
Seasoned investors have traded out of positions and lightened up in certain areas, as to be expected in a down-credit cycle. However, the biggest change in the investor base this year has been the new capital dedicated to secondary CDOs. "There are a lot of funds set up to invest in secondary CDOs, or have received allocations for secondary CDOs," noted Ganapati, calling the trading of both clean and distressed secondary CDOs the market's hot spot of the year.
Lehman Brothers calculated that roughly $10 billion in securities has traded in the secondary market year-to-date. "The amount of liquidity infusion has been dramatic," said Ganapati, noting the significant compression in the spread differentials between the primary and secondary markets so far. Cleaner triple-A secondaries are trading at Libor plus 55 to 65 basis points over, as opposed to pricing in the Libor plus 50 to 55 basis points over area in the primary market, she said. That differential was 25 to 30 basis points wider at the beginning of the year.
On the leverage loan side collateral spreads have come in, but many new transactions that started buying collateral two to three months ago will still get issued at attractive arbitrage levels, Ganapati stated. "Going forward, it really depends on whether levels of leverage loan issuance volume go up or not. The sentiment is that they will go up, because of [the pickup] in M&A activity, bankruptcy exits and continued refinancings."
After the negative effects of the credit cycle, the traditional buyer base found itself on the sidelines earlier this year, but is starting to trickle back. However, these buyers are now competing with the hedge fund community, which took a keen interest in cash and synthetic secondary CDOs. "We're seeing more activity from them this year than in past years. Dislocation in pricing [attracts hedge funds] whereas other investors do not always have the mandate to take advantage of that," said Ganapati.
The main attraction for this newer investor base? "Where cash secondary CDOs were valued in the second half of 2002 was extreme. It was incredibly cheap to fair value, and when you have a dislocated market it's just a matter of time before people come in and take advantage of that," she explained.
The leap in CDO technology is probably best expressed this year in the increased levels of correlation capital dedicated to dealer desks trading in correlation risk. As a result, the amount of customized CDOs has skyrocketed as investors take advantage of the increased ability to hedge the underlying risk. "Because of this technology, and dedicated correlation capital that hedges using the default swap market, Wall Street desks are able to create customized tranches tailored to the investors' risk profile," said Ganapati.
Customized CDO technology is heavily favored by the European investor base looking for diversified credit product. "The technicals there are very strong, as many investors are looking to put on quick exposure to the credit market at their desired risk level. I continue to see this being a force of growth in the market for the foreseeable future," she said.
On the other hand, the dramatic tightening in default swap spreads has dampened issuance in recent weeks to some extent. "That may slow growth in the short term but as a feature of the market, they'll always exist. There will be times of less issuance and times of increased issuance," said Ganapati.
Other drivers of growth on Ganapati's list include structured finance CDOs, or ABS CDOs, and leverage loan CDOs, which have dominated the cash flow market landscape this year.
However, while overall global issuance has grown this year, according to Lehman's figures, U.S. arbitrage issuance dropped by 17%. Overall global CDO volume was up 24% during the first six months of the year, thanks to customized synthetic tranche issuance, and driven largely out of Europe. Close to $62 billion in funded par priced in the first half of 2003 in the synthetic market, and Lehman tracked close to 265 customized synthetic CDOs in the first half of the year, of which more than 100 were single-tranche CDOs, a rare statistic as these synthetic vehicles are extremely hard to spot.
Perhaps the best reason present this year for investing in CDOs is the nature of the vehicle itself relative to comparable securities. At roughly $500 billion outstanding, CDOs are widely regarded as an efficient way to add diversified credit exposure, and trade with liquidity premiums attached. "The volatility in liquid spread sectors including corporates and mortgages has underlined the diversification provided by buy-and-hold products such as CDOs," said Ganapati.
"If your view is that the credit cycle has bottomed and we've really come out of the worst that we saw last year - which is what all the statistics are saying - CDO tranches continue to trade wide relative to what their underlying portfolios are reflecting in terms of risk. Primarily, this is because CDOs tend to lag the underlying markets, both on the way down and the way up," said Ganapati. "For example, as recovery rates improve, CDO valuations are likely going to get much better, mainly in second priority, non-PIKable tranches and subordinated tranches of clean leverage-loan CDOs."