The pace of issuance of collateralized debt obligations for the first few months of 2000 has been relatively slow. Approximately 20 transactions have closed since January. This low number does not accurately reflect the dynamic nature of the market. As you can see from the chart [below], CDO issuance has been breaking records for the past few years. Total Moody's-rated volume of CDO securities is almost $280 billion. Despite the slow start to the year, the thirty-five member rating team at Moody's is currently reviewing 80 possible transactions. This may not result in 80 closed transactions, but it is fair to project that more than 40 will eventually make their way to the desks of investors. These numbers are significant when one considers that market sources estimate that CDOs currently hold as much as 17% of all high-yield bonds and 25% of leveraged loans.
The slow start for the year can be partially explained by the phenomenal issuance at the end of 1999. Concerns about Y2K and lack of market activity in the fourth quarter could not have been more wrong. December was the most active month ever for CDO issuance. This high level of issuance in effect accelerated some transactions which might otherwise have closed in early 2000. Other reasons include the dearth of supply of assets, especially in certain industries. Bankers also searched in vain early in the year for the adequate spread differential between assets and liabilities in order to place all elements of their CDO capital structure economically. This may have been compounded by banker vacations recovering from the 4th quarter issuance spree and bonus payouts! Other more profound causes would include investor concerns regarding CDO downgrades and the increase in high-yield default rates.
In this regard, of the more than 420 CDO transactions Moody's has rated since 1988, only 25 have suffered downgrades, excluding credit-linked transactions and some non-public shadow ratings for wrapped deals. It is important to note that no Aaa-rated or Aa1-rated tranches have been downgraded from their original ratings. Common causes of downgrades are a decline in the credit quality of the underlying collateral pool (especially emerging market) and deterioration of overcollateralization in the structure, the latter of which is often driven by the sale, at a price below par, of more risky or defaulted assets. The migration of CDO ratings that we have observed thus far is in line with our expectations, especially with the lower-rated tranches which should move to reflect changes in credit quality of their underlying assets. CDO ratings are in fact more stable than those of corporate bonds. We anticipate publishing a research report in the next few months discussing the migration of CDO ratings relative to those found in the extensive database of Moody's corporate bond.
The large pipeline of transactions at Moody's presumably is the product of the excellent environment for CDO issuance currently. Chief among the reasons supporting issuance is the tightening of spreads on the liabilities and a concurrent widening of the spreads on assets most often securitized. Swaps spreads, which are important to the success of these structures, have also become more favorable. And, as rating agencies and investors have become more comfortable with the adaptation of existing methodologies to allow for the inclusion of different types of assets, problems finding assets to be included in portfolios have become less acute.
Trends we see for this year include the continued growth of the "resecuritization" transactions including CDOs of ABS, CDOs, CMBS, MBS, and REIT bonds and continued tiering of CDO managers. There is also intense interest in structuring European leveraged finance deals. In addition, there are several regulatory initiatives which may impact the CDO market. Chief among them are the Basle and Fed risk-based capital proposals and possible changes in ERISA eligibility of some structured transactions. In addition, underwriters and managers have been working together to create greater transparency with respect to transaction information which should have the happy result of increasing liquidity in this asset class.
Institutions considering investing in these transactions must carefully review all the documentation received and make a point of investigating any CDO manager. This should include calls to the analysts at any rating agency working on the transaction to discuss their view of the manager and any concerns the analyst (or investor) may have. The trustee for the transaction should be reputable and understand all aspects of the indenture. It is essential that the trustee and manager work closely and cooperatively together. No matter where you are in the capital structure, if the answers to your questions and due diligence do not satisfy you, you should continue to investigate until you are happy or wait for the next deal. Given the current pipeline, there is sure to be something interesting coming along soon.
