The same quest for arbitrage that spawned last year's wave of collateralized bond obligations is causing a wave of other, alternative and non-traditional CBO structures - including the innovative use of guarantees and credit risk default transfer structures.

As a tag-on to an actively managed fund (typically a hedge fund), the PPO, or principal protection option, which was originally brought to market last June in Ferrall Capital Management's Concert Series I, is gaining investor interest, while similar transactions are said to be on the slate.

"It's definitely an alternative to a CBO," said Jennifer Williams, a vice president at Ambac, which is participating in the development of the structure. "It's less legally comprehensive than a CBO, but it's still structured through a special purpose vehicle, so there's still limited debt and a limited number of creditors, and it still gains assets under management for the manager."

Essentially, the PPO transfers a share of the fund into a debt instrument, which can be rated, translating into better capital treatment for investors.

As with most funds, when buying a share, you're buying an equity piece - which is based on the net asset value of the collateral.

"To turn the market value volatility into a debt form you can add this PPO, which means that if the volatility leads to the net asset dropping below a threshold, the guaranty behind it will pay the investor back the principal or the pre-determined value," Williams said.

In terms of analysis, the PPO is much more inline with what would be performed on a market value CBO than on a cash flow CBO.

"So it's not a matter necessarily of probability of default and loss recovery, which is much more cash flow oriented," Williams said. "It has to do with the price volatility of the assets."

The PPO structured bond will price at levels slightly above a comparable asset-backed security, because it's new, Williams said.

The Concert I Series, in which National Westminster Bank provided the enhancement or PPO, priced at one-month Libor plus 40.

Though the PPO enhanced fund is a simplified alternative to a CBO in terms of capitalization - meaning it's structured in two parts, a senior and income piece, where a market value CBO is generally multi-tranched - the PPO is technically asset-backed, as it's backed by the asset value of the collateral in the SPV, Williams said.

In an transaction that removed a large portion of credit risk - as opposed to the principal risk - Warburg Dillon Read last week priced a $1.2 billion CBO designed to protect investors from every sort of risk but default.

Warburg parent UBS will take most of credit risk of underlying collateral, including spread widening, prepayments and trading losses (see story p. 2).

Cross Collateral CBOs

In asset-backed land, the most talked about non-traditional structure is, of course, the CBO backed by asset-backeds, coined re-securitization, or re-repackaging

"We're seeing a fair number in the market or in development, where the underlying asset is not the high yield bonds but the repackaging of asset-backed securities," said Scott Gordon, a managing director at Ambac. "Bankers or other sponsors are gathering portfolios of a variety of different types of asset-backed securities, and using CBO technologies to tranche and fund the transactions."

Though notoriously picking up the more subordinated pieces of transactions, the CBOs don't necessarily have to be backed by subordinate tranches. Mezzanine tranches as well as investment grade or near investment grade pieces of asset-backeds could be candidates for CBOs, said Laurie Evangel, head of CBOs at MBIA.

"Sometimes even the triple-B tranches of asset-backeds are not very liquid," Evangel said. "So they might have very decent spreads, so you could put those in."

While the typical collateral managers for U.S. high yield CBOs range from insurance companies, to banks, to hedge funds and retail money managers, for the asset-backed CBO, the portfolio managers that bring the deals will likely be determined by the collateral type.

"The managers that you're going to see for CBOs of asset-backeds are niche players who are already buying these asset-backed tranches, and they know these asset classes enough to package them together for a leveraged yield," Evangel said.

As for pricing, asset-backed CBOs vary in comparison to their high yield brethren.

"It depends on what type of ABS," said Ambac's Williams. "Most of the well seasoned ABS, like credit cards prices according with high-yield debt, and sometimes even better."

Investor Demand

Among other significant developments relating to a maturing collateralized debt obligation market, standard criteria, reflected by investor demand for quality product, is being set down.

This is in part a result of a slew of under-performing CBOs issued in the past few years.

"A lot of folks bought these CDOs where the underlying credits deteriorated significantly," said Ralph Boynton, of Ferrall Capital Management. "It's on everybody hit list as buyers."

Boynton, who sat on a CDO panel at a recent conference hosted by the Information Management Network, identified five major qualities that investors are expecting to see when shown the new CBO and CBO-like products.

1)Lack of correlation to other markets in the performance of the securities

2)Total transparency

3)Liquidity of the underlying assets, whether loans or high yield bonds

4)Credit worthiness of the underlying instruments.

5)Real time accurate pricing of the underlying assets

"The customers for CBOs are generally the bigger insurance companies and banks and they just simply are demanding these standards," Boynton said. "No longer can people put things in black boxes, and no longer will people buy things that are not liquid."

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.