By Lang Gibson, Director of Research, Structured Credit Products, Banc of America Securities
Jonathan Prestley of Hartford Investment Management Co. (HIMCO) asked six topical, poignant questions of the CDO Research Panel at this week's IMN CDO Conference in New York City. The following is BofA's Structured Credit Research's response to these six questions on the state of the CDO market.
HIMCO Question #1: Ratings Volatility - We've seen a lot of downgrades of CDO tranches in the last year, even including several triple-A-rated bonds. In hindsight, were HY transactions overleveraged, given the volatility of the underlying assets?
SCP Research Response: For the most part, we do not believe CDOs were overleveraged, though there were some structural features that had unintended consequences. In 2001, on average, downgrade rates for HY bond CDOs and synthetic B/S CDOs were more than that of corporates in certain rating categories. For instance, the Moody's Investors Service Aa2 HY bond CDO downgrade rate was 25.6% versus 16.3% in same-rated corporates. Further, the downgrade rate for Baa2 synthetic B/S CDOs was 33.3% versus 14.8% for corporates. We believe this trend may continue through much of 2002 before abating due to the time-lag in re-rating CDOs in response to collateral downgrades, which themselves lag market pricing.
Despite the record 2001 CDO downgrades, which quadrupled the number of tranches downgraded in 2000, we suspect severity of CDO downgrades (in terms of number of notches) have been less than corporates overall. Further, CDOs are structured to withstand a 12-year default cycle - not just one period, and the empirical average for default indices is between 3% and 4%. Since CDOs have been hit by a combination of front-loaded defaults and record low recovery rates, pre-2001 vintage CDO downgrades will be lumped into 2001 and 2002 but much lower vis-a-vis corporates in the remaining ten years of their lives. Lastly, with few exceptions, only proven managers with a track record of outperforming these indexes are now allowed entry into the market, particularly since Sept. 11. Therefore, we can expect substantially better performance of post-2001 vintage CDOs, particularly when we factor in the wider funding gaps prevalent in these structures and improved structural characteristics as discussed below.
HIMCO Question #2: As a follow-up, have structures evolved to withstand the current high levels of defaults?
SCP Research Response: Yes. Structures have evolved to offer more protection for the senior-most noteholders, preserve excess interest in the deal and to mitigate O/C compression. Further, there is more emphasis on maintaining a fair balance between the debt and equity holders. An example of a structural innovation we have seen in recent deals has been the Interest Deflection Test, which diverts excess spread away from equity holders into the purchase of additional collateral well before O/C levels hit their triggers to deleverage the deal. Some structural features implemented in the early days of CDOs have been found to be detrimental to most of the noteholders in a bearish environment. For instance, old rules required managers to preserve par through their trading. Although this tactic preserved par, it encouraged trading risky assets for other potentially risky assets, which can be detrimental to the deal. Therefore, this feature has been removed through the evolution of the structure. Overall, the market has been very quick to detect any deficiencies in old structural rules and adapt them to help deals weather a market of higher than expected defaults and lower recovery rates. We believe that if recovery rates had withheld their historical averages, most deals would have withstood the current high level of defaults, which have been no higher than those levels used in the rating agencies' stress scenarios at deal initiation.
HIMCO Question #3: The Enron effect - Enron was held in many investment-grade CDOs. How has its demise affected these deals and the IG market in general?
In IG CDOs, the only losers have been the first-loss holders. However, corporate bond investors have suffered across the board from triple-B spread widening. The major impact has been on the IG market, which has caught a spell of Enronitis in which certain companies have been associated with accounting fraud, disclosure issues, and liquidity deficiencies. The only real impact to date has been primary IG CDOs pricing 10bps wider in single As and 35bps wider in triple Bs to competing CDO sectors. The new issue market has remained fairly steady. At least eight IG CDO deals have priced this year out of a total 22 visible transactions globally. Further, in our visible pipeline, there are currently 26 IG CDOs out of a total 90 deals globally. Most of the priced deals and deals in their marketing stages are synthetic, as the funding gap for cash deals remains tight considering there were approximately 20 IG defaults in 2001. Nevertheless, we do expect IG static portfolio default swaps to evolve to offer more senior note friendly features such as waterfalls and additional credit enhancement similar to cash arbitrage deals. Further, we will see super senior swaps in these deals be further tranched out to allow certain investors such as reinsurers to increase swap fee/notional ratios.
HIMCO Question #4: Is there value in the secondary market and is there anything for sale other than distressed bonds?
SCP Research Response: Most of what trades is senior notes, particularly in terms of principal amount. Whereas senior paper moves in blocks of $25 million to $50 million, subordinate tranches move in blocks of only $5 million and $10 million. In stressed and distressed paper, there is value for smart buyers who must be able to reverse engineer the bond with top-notch analytical capabilities and technology. For distressed' bonds, they might have a strategy to buy at $50 and subsequently sell at, say, $70. Whereas for stressed' bonds, they may buy at $75 and sell at $85, or hopefully par if bond is cured. In non-stressed paper, liquidity premiums are so large that long-term holders can find value even in good quality paper, which cheapens up significantly right out the door. Last year, bonds in secondary market originated from forced sellers under regulatory and accounting constraints (e.g. EITF 99-20). This can spell opportunity for buyers not affected by such restrictions. Further, in recent months, in the face of substantial downgrade activity, many CP conduits have been forced to sell paper downgraded from double-A or triple-A to single-A, which they are not permitted to hold.
HIMCO Question #5: Transparency (analytics, valuation, surveillance, total return indices). Have we made any progress?
SCP Research Response: Almost every dealer has a CDO research group with regular publications showing an abundance of practical analytics and data, which is easily accessible by their buy-side clients. Regarding valuation, Wall Street Analytics and Intex deliver robust deal modeling on well over 100 deals to their clients. Even with this tool, valuation still requires a balance of art and science. For surveillance, Fitch Ratings provides standardized surveillance on all its rated deals for website subscribers. Moody's will do the same in a few weeks as well as start providing a robust analytical package on each deal for an additional fee in the middle of this year. Lastly, we need Street collaboration for total return indices to be created. Due to CDO complexity and heterogeneity, the convention is for the deal's arranger to provide marks to clients. If all this data were to be compiled by, say, a third party CDO analytic vendor, price indices could be available across all rating categories.
HIMCO Question #6: What are your views on relative value (among CDO sectors, versus fixed income alternatives, versus stocks and alternative investments)?
SCP Research Response: Among CDO sectors, we believe HY CBO notes stand to benefit from lackluster supply and currently wider spreads versus HY CLOs. Further down the capital structure, HY CBO equity has significantly higher IRRs versus all other cash CDOs. The base case IRR according to our CDO barometers is 25.5% versus a range of 14% to 22% for the competing three sectors. In the stressed case, HY bond CDO equity IRRs are 15.5% versus a range of 10% to 13%. Even on a risk-adjusted basis, at these levels, we see relative value for HY CBOs. Lastly, synthetics can have value to cash CDOs due to their liquidity premiums, equity upside in many triple-B tranches and higher WARFs due to the low cost of the super senior swap resulting in less downgrade volatility.
Among fixed-income alternatives, CDOs have the best spread for any credit sensitive product due to a complexity, liquidity and newness premium. For instance, triple B CDOs have a 200bp pick-up to industrials and 130bp pick-up to banks; while single-A CDOs have a 100bp pick-up to banks and 115bp pick-up to industrials. In, ABS, single A CDOs have a 100bp pick-up to autos. As compared to respective ratings in CMBS, triple-B, single-A and double-A CDOs have a 155, 65 and 20bp pick-up.
CDO Equity IRRs of 20% to 25% in the base case and even a 10% in a stressed case appear attractive in the current stock market environment. Of course, the major give-up in CDO equity versus stocks is liquidity. Lastly, we see value in CFOs. When hedge fund collateral return is greater than approximately 8%, CFOs provide superior leveraged returns to hedge funds.