Collateralized debt obligations backed by high yield bonds are a rare breed these days. While the product enjoyed popularity among CDO investors in the past, thus far in 2002 only four high yield CBOs have come to market. Among other factors, with the surge in downgrades to existing transactions over the last year or so, high yield CBOs are a tough sell at best.

While HY CBOs have been as much victims of the economic downturn as other investment vehicles - perhaps even more so, given the abysmal performance of high yield debt - experts say it will take more than a turnaround in the economy and the asset class to restore credibility and attractiveness. Indeed, the very structure of high yield CBOs and the philosophy guiding this, they say, need to change before the product can regain some of its appeal.

For one, structurers, managers and dealers need to set realistic expectations of what investors can expect by way of returns, says David Tesher, managing director at Standard & Poor's. Gone are the go-go days of the high yield CBO - from here on, managers need to use leverage responsibly, Tesher said, and most importantly, transactions should incorporate certain structural mitigants that would improve their credit quality.

Both S&P and Moody's Investors Service have proposed a series of structural changes for CDOs (high yield CBOs in particular), which include beefing up standard overcollateralization tests, using supplemental O/C tests to ensure cash is diverted from lower tranches early on and can be reinvested, and prohibiting managers from investing in lower-rated credits on watch for a downgrade, especially if the vehicle's triple-C bucket is already nearing its threshold.

Some of these measures have been incorporated in deals, Tesher says, but there is still room for more.

Danielle Nazarian, vice president and senior credit officer at Moody's, agrees.

"Change has been coming gradually," he said. "Some bankers are using the features in the majority of deals they underwrite, but change is still more on a deal-by-deal basis."

Debt above equity

The main grouse many have had against high yield CBOs is their partiality toward investors in equity tranches. Traditionally the hardest

sell for other CDO types, collateral managers have had little difficulty tempting equity investors in high yield CBOs, says Douglas Lucas, CDO strategist at UBS Warburg.

To the detriment of debt holders, many of them focused on par building trades that kept cash flowing to equity tranches even after it became clear the deals were heading into trouble.

The measures proposed by Moody's and S&P aim to establish an equilibrium between equity investors and debt investors, particularly those investors in the mezzanine tranches of high yield CBOs, who have been the hardest to entice.

"Equity is vital to a deal, but equity investors should not be expecting large returns when the underlying collateral is performing so poorly," Nazarian said.

Not everybody, however, feels there's a need for stringent structural changes to high yield CBOs. Alex Reyfman, CDO strategist at Goldman Sachs, argues that debt investors themselves are capable of making their allocations with or without structural changes, and are more than able to decide where they can get a good deal.

"[CBO transactions] are fairly complex as it is, and while there needs to be structural protection for the debt classes, it needs to be as simple as possible," Reyfman said.

The measures suggested by rating agencies, he says, make the process of managing a CBO "more difficult in a non-economic way." Managers who have bent or violated the spirit of existing rules would probably violate new ones, too, Reyfman said, so it makes little sense to have them.

"The market is quite aware of instances where managers have gone against the spirit of CBO transactions, and those managers have been locked out of the market," he argues. "This is the way it should work: if a manager is managing a deal in a way that is detrimental to one class of investors, that should be reflected in the pricing of subsequent transactions."

The market has indeed been able to differentiate between managers, S&P's Tesher said, and those who don't have strong track records are finding it difficult to bring new deals.

Moreover, it might be detrimental to the asset class if it becomes overcomplicated. As Moody's Nazarian said, CDOs are complex transactions, and simple concepts can become complex when applied to them.

The ideal solution for the future of the high yield CBO as a viable asset class, Warburg's Lucas said, lies in a "middle ground," which incorporates structural changes suggested by all parties, rating agencies, investors and banks such as UBS Warburg (the firm recently came out with a set of its own recommendations).

"While debt investors have gotten a bad deal in many existing CDOs, everyone must recognize that CDOs cannot exist without equity holders," he wrote in a recent report. "We are confident there is a broad middle ground of CDO terms and conditions where both sets of investors receive a fair return for the risks they assume."

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