SOUTH BEACH, Fla. - Market players at the Strategic Research Institutes's ABS Industry Summit last week noted that trends in the investment-grade sector of the CDO market are toward higher-quality credits in the collateral pool, restrictions on asset manager activity and increased protection of the mezzanine classes - even at the expense of equity investor returns. In fact, changes in rating agency methodology for future transactions will be designed to prevent perceived abuses on the part of asset managers.
"In the same way that the high-yield sector has moved into loans as collateral, the investment-grade [CDO] market is starting to move into higher-quality names and solid credits, noted Joe Schlim, a partner at Aladdin Asset Management. "We will no longer seek 40% yields on collateral investments."
The goal is to decrease the collateral volatility that has driven the high-yield sector into obsolescence, propelling asset managers into both positive and negative par-building trades. The unprecedented number of corporate downgrades so far this year has generated a drive to limit the damage that can be caused by asset managers attempting to boost equity yields at the expense of bondholders, or the chances of mistakes being made through sheer inexperience. "Investors don't want managers to learn the nuances of asset management on their dime," said Mike Rosenberg, a managing director at JPMorgan Securities.
Moody's Investors Service assistant vice president Natasha Chen cited the 50 fallen angels the corporate world has seen in 2002 - on pace to top the 60 seen last year. There have been seven corporate downgrades for each upgrade, which worksout to a 32-to-1 ratio on a debt-outstanding basis. The $145 billion in defaults year-to-date already tops the $135 billion seen during all of last year.
Volatility can be
nullified, added JPMorgan's Rosenberg, via a responsible par-building strategy in managing the collateral pool. Even CDOs with exposue to both Enron Corp. and Worldcom are performing satisfactorily, he added, because those managers have continued to build par.
One change likely to be initiated by Moody's is the re-investment of excess spread by managers rather than paying it out to equity holders - particularly into the mezzanine tranches, which have become the most difficult sell in the market. Moody's would also like to treat corporate debt on negative credit watch as having already been downgraded. "[Triple-B] rated bonds on watch for a downgrade are ten-times more likely to have their ratings cut," Chen added.
Managers rarely trade out of debt on the cusp of junk status, seeking higher yields in order to keep equity investors happy. But with a plethora of equity investors and a paucity of mezzanine buyers, more needs to be done to protect debt investors.
Moody's intends to limit trading gains that managers can pay to equity holders in the future, and if the agency detects or even suspects a pattern of activity that threatens bondholders, it will require mezzanine bond protections be put in place. If the asset manager refuses, Moody's will stress for the behavior and then structure the transaction accordingly.
In synthetic investment grade CDOs, investor preference is moving away from managed deals, as the primary investor base - insurance companies - is already well schooled in analyzing derivative credit risk and would prefer not to pay additional fees for a manager's services.