The revolution in collateralized debt obligation instruments just took another turn, as that market awaits the debut of cutting-edge CDOs backed by hedge fund debt and municipal bonds, among other possibilities.

Ferrell Capital Management is now pre-marketing $50 million of unrated junior notes that are in part based on the performance of a group of hedge funds. Ferrell's deal program is considered the avant garde of the CDO market, as it is less legally comprehensive than a typical CDO, yet retains the basic structure. However, other deals are in the works that could make the Ferrell program seem passe: in particular, CDOs backed and managed entirely by hedge fund managers. (CDOs basically bundle cash-flow producing debt obligations into a synthetic structure.)

While other debt markets like corporate bonds have seen innovation fall by the wayside in recent years, CDO issuers are constantly playing a game of one-upmanship. In the last year alone, there have been first-time deals backed by project finance loans, distressed debt and even CDOs built out of existing CDOs.

The reason for the innovation spree is simple: The market is hot and investors can't seem to get enough of the product. That in turn is leading all sorts of debt issuers, from fund managers with large holdings of tobacco legal settlement bonds to European high-yield players, to investigate the market. Aggregate CDO issuance was roughly $120 billion last year, up from $72 billion in 1999, and volume will likely be even higher this year. The market's hot streak began in 1996 and has steam-rolled forward ever since.

For players in high-risk markets, such as hedge funds, CDO issuance provides a new and possibly lucrative method to gain arbitrage.

"As the [CDO deal] technology begins to proves itself, people are saying, We can start bundling other things, as long as there's an arb opportunity'," said Henry Albulescu, a director at Standard & Poor's.

The class of 2001

Rating agency officials said they have received a number of new CDO proposals in recent months, and that many pioneer deals have a good chance of coming to market. In addition to the upcoming Ferrell hedge fund deal, which will be issued by asset managers on a portfolio contributed by hedge funds, there will likely be CDOs issued directly by hedge funds, thus eliminating the third-party issuers from the equation.

The Ferrell deal is backed primarily by DKR Capital's AIG International Relative Value Fund, which acts as the underlying asset in the deal via an $200 million investment. The fund invests primarily in commodity and currency arbitrage as well as domestic and European merger arbitrage opportunities. Links Securities Inc. is acting as placement agent for the deal along with Ferrell.

While market players are excited about the deal, they are even more intrigued by hedge fund managers running their own CDO programs. "I think hedge funds will enter into managing CDOs by viewing it as a supplemental product they can offer," said one analyst. "There will be no hard rules on what they put in there, and they can give a high enough return on equity to make it a good investment."

Rating agency officials said that while they are open to any sort of deal proposal, they would prefer that the first hedge fund deals were of high debt quality. Hedge fund CDOs "that focus more on investment-grade, highly liquid assets would be ones that we would be more comfortable with," said Noel Kirnon, group managing director of structured finance at Moody's Investors Service.

There is also at least a 50% chance that some sort of CDO backed by municipal debt will hit the tape before the end of 2001. It seems strange at first glance that the muni bond market has not already taken advantage of CDOs. After all, much municipal debt is liquid, well-regarded and generally investment grade, while the far more troublesome high-yield corporate bond market has instead been a major participant in CDO issuance since the paper's inception.

One problem is that there is still controversy about ratings transfers. Bundling together bonds from a variety of municipalities will require a new overall rating for the deal, which could mean that previously highly-rated muni bonds could get downgraded, or vice-versa, depending on the overall quality. Also, the rating agencies have yet to issue any methodology of how to accurately predict default potential for muni CDOs, although such a methodology is expected soon from a number of rating agencies.

A likely issuer of municipal CDOs are insurance companies, which tend to keep large books of muni debt, and which are always looking to gain further credit protection on their investments. Bundling muni bonds and selling off the risk to investors would be a popular strategy among insurers once the deals catch on, observers said.

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