Granted spread tightening has been a factor across numerous asset-backed markets but none have responded with the panache that the CDO market has. Three innovations have grown in popularity this year, including a brassy new structure that harnesses collateral in the high yield bond market.

In an effort to find relief from tightening credit spreads, the CDO market responded with CDOs of CDOs but didn't stop there, says Frank Iacono, senior vice president at Lehman Brothers. Synthetic high yield bond CDO structures began to hit investors' desks with increasing frequency this year, and Lehman melded together a synthetic CDO structure with an interest rate feature and a step-up mechanism to reduce credit exposure.

"It's not to say these structures weren't done before this year, but 2004 is really the year these products have taken off," said Iacono, a speaker The Bond Market Association's CDO Conference in New York this week. "Since the fall of 2002 there's been a pretty sustained rally in credit spreads...that reduces what we're able to pay on the synthetic CDO tranches, as there's less spread to go around to different participants in the capital structure."

In the wake of so much constriction on payments, collateral in the high yield bond market became increasingly eye-catching, resulting in synthetic high yield bond CDOs.

"One driver of high yield synthetic CDOs coming into their own this year is the rating aspect," says Iacono, explaining that because of the higher default risk in high yield credit, high yield structures are built with more subordination in them. For example, a triple-A tranche off a high yield collateral pool should have approximately the same amount of risk as a triple-A tranche off an investment grade collateral pool, and in order to accomplish this much more subordination is required for the high yield pool, he says.

"But first and foremost we needed a liquidity market in a broad universe of high yield credits before we could even think about doing any of this. And for the first time this year, we saw a liquid market emerge," Iacono notes.

The investor base interested in these emerging securities hasn't diverged much from the usual suspects, with insurance companies, banks, asset managers and high net worth investors partaking in these deals. This audience is getting paid much more in a synthetic CDO structure, for taking the same amount, or a comparable amount, of default risk, Iacono says. High yield transactions are "getting done with more frequency now than in January, February, definitely," he says.

And as synthetic high yield bonds blossomed this year, so has another unique synthetic structure. Lehman Brothers executed its first synthetic CDO with an interest rate feature in April. In fact, the dealer sold three such deals this spring; all were 10-year structures of fixed rate, single-A class and triple-B class notes. In excess of $125 million of single-A and triple-B bonds were purchased by investors.

Described as referencing a portfolio of 100 investment grade names, the deals were unique in that they had two features: an interest rate feature in the form of fixed rate, callable bonds and a subordination step-up.

Iacono explains the interest rate feature, where the bonds were callable after a specific lock-out period, allowed for enhancement of yield. If the bonds were not called, year five featured a subordination step-up, which mitigated credit exposure in the latter years of the deal.

"It's as if it is a 10-year deal but if continues past year five, more equity comes into the structure to support the rated notes," says Iacono. All three of the Lehman transactions were performing well, without any defaults reported in the structures and a slight tightening of the spreads on the credits in the portfolio.

Of course, with the newer models now being driven off the lot, so-to-speak, CDOs of CDOs have some more competition for investors' attention. But this structure has increased in popularity in 2004, Iacono says, being the original response to counterbalance the rally in credit spreads. "A key driver of the synthetic CDO squared structure was the need to continue to pay investors attractive spreads on rated classes in the face of an overall tightening in the credit market."

The synthetic world is not all that different from cash flow CDOs, Iacono believes. "It's corporate credit default risk. Sometimes there are different accounting treatments...but in some ways they're actually simpler than traditional corporate CDO structures," he explains, pointing to cash flow waterfalls. "Traditional synthetic structures really don't have cash waterfalls at all. It's keeping track of how many losses there are in the portfolio. So long as default losses stay below the specified threshold, you're going to get your money back."

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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