Metropolitan Life (Met Life) has launched and priced its first investment-grade a $507 million cash flow CBO called Madison Avenue II, via Salomon Smith Barney. The $415 million triple-A rated tranche priced at 48 basis points over six months libor. Although the A-class priced at par, several investors believed the collateral was far too leveraged. Moody's Investors Service and Standard & Poor's rated the transaction.
Madison II has a 5% equity first-loss piece compared to a typical high-yield CBO with a 10% cushion.
"It doesn't take too many fallen angels to get an investment-grade CBO into serious trouble," said one portfolio manager. Although the bottom equity tranche in a CDO typically absorbs the first losses in a deal, investors above the equity can suffer losses as a result of portfolio restrictions forcing them the to sell the defaulted bonds at whatever price is available at that time.
"After the recent downgrades that we saw with Finova Group, Pacific Gas & Electric, and Southern California Edison we'd rather have the bigger cushion and less leverage than high-yield CBOs typically have," added the portfolio manager.
For example, Berkshire Hathaway and Leucadia National recently put a deal on the table to take over the once investment-grade Finova Group as the company prepares to file for one of the largest Chapter 11 proceedings ever, with some $11 billion of outstanding debt.
When asked why Met Life decided to go with an investment grade issue, Charles Scully, a director in the insurance company's securitization department said, "Met Life is a major investor in investment-grade corporate bonds and working with investment-grade collateral is something we do everyday and do well."
"In November the market started to cheapen-up and we were able to (completely) ramp-up a portfolio at a cheap enough price by February to do this deal. We had a 100% of overlap of bonds that Met Life already had in its other portfolios under management."
The top three industries in Madison II's dynamic pool of bonds are financial intermediaries, telecoms, and utilities. Additional sectors adding significantly to the pool are chemicals, plastics and rubber. Hard asset collateral like the ones in this pool provides higher recoveries than what Street analysts refer to as "concept companies" with little plant and equipment value.
"We purchase companies in the telecom sector that we are comfortable with and are established," Scully said, when asked about the deterioration in the telecom sector.
Madison II's estimated default rate for its USD $26 million equity piece is between 25bp and 50bp with an internal rate of return between 15% and 18%. There are 120 bonds in the portfolio and estimated recoveries are between 40% and 50%, sources at Salomon Smith Barney said.
Michael Kroger, an MD in Met Life's investment department, is the primary portfolio manger responsible for Madison II. Met Life's strategy is to issue two or more CDOs per year and has one new issue in the pipeline for in the first half of this year, sources said.