While many traditional private investors stay away from the lower end of the credit spectrum, a number of advocates of riskier tranches say the addition of subordinate asset-backed bonds can significantly enhance a private placement investor's portfolio.
"If you are comfortable with the senior securities, it makes sense to start looking down a bit at lower-rated tranches," said Sheila Sohr, managing director at PPM America.
Even in somewhat volatile market conditions, several investors like Sohr echo that sentiment. In fact, some buyers are even seeing increased opportunity to buy lower-rated deals as most investors flock to safer, higher-rated issues.
Indeed, some insurance companies, which have always traditionally invested in double-B and triple-B rated securities are putting more toward subordinate tranches, including snapping up single-B opportunities, sources say.
Part of the reason for the increased interest in this area can be blamed on the phenomenal growth in collateralized bond and loan obligations, which use these securities as underlying collateral.
"A secondary market is going to be growing out of a need for more CBO product from different types of buyers," said Bruce Maier, vice president at Structured Finance Advisors. "As the CBO market is trying to accumulate collateral [the subordinated market] may be a basket for activity."
When Good Deals Go Bad
Yet even with the greater interest, market participants maintain that subordinate investing must be done with extra care.
It requires timing, good relationships with seasoned agents and an exhaustive amount of due diligence. "When looking at emerging market or new asset classes, corporate data is hard to find," said one market pro. "You need to do all the stress tests and what ifs'."
Much like spreads, the risk involved only increases when the bonds are from cross-border or emerging-market transactions. "We try not to do weak credits in weak countries," said Sohr.
Timeshare loans, franchise loans, music royalties, mutual fund fees and leasing transactions were identified as providing the most valuable opportunities in the subordinate market.
"We like to look at the pricing on the underlying collateral especially with CBOs," said Sohr. "We've seen some with problems and if you look at the underlying capital you'll notice it was at a time of very tight spreads."
She also stresses establishing a "framework" for pricing, looking at relative value across all sectors in the private and public asset-backed securities markets.
Often you are the lost piece," said Maier, adding that the reality of investing in subordinate pieces means bearing the brunt of the punishment when a transaction goes sour. "The subordinate piece is probably going to be affected. The equity portion, which is usually small, gets eaten up pretty quickly."
Running Down The Monoline
And while monoline wraps, a popular mechanism in the structured finance market these days, may make transactions cheaper for issuers and ultimately safer for senior buyers, many subordinate investors still get the willies.
Sources say that as the "third party" in transactions, monoline insurance companies are on the line to ensure payment of bonds, especially to senior holders, and as such can shut off payment to subordinated note holders.
"A monoline has to react very quickly," said Maier. "If a monoline is in [the transaction] we will ask for a lot more due diligence. Third-party agreements will affect the sub holder maybe even more than the original documentation."
Still, even though the risks are great for subordinated-note buyers in credit wrapped transactions, investors still flock toward them. As one investor put it, "People do it, but I'm not sure how they deal with [risk]."
