CDO issuers promise portfolio diversification

Collateralised debt obligations offer exposure to esoteric asset classes such as high yield corporates and leveraged loans. The issuance of collateralised debt obligations (CDOs) has undergone an explosion in the past few years, even though they have been part of the structured products landscape since the late 1980s. Aggregate issuance in 2000 reached a record peak of just over $120bn (according to Moody’s) and is expected to be slightly lower in 2001. However, the number of deals rated in 2001 will exceed the number in 2000. This growth is remarkable, considering that volume in 1995 was only about $5bn and in 1996 was still only about $20bn. Supply of CDOs is driven by two distinct goals of an issuer. One goal is to remove assets from the balance sheet, either as a means of managing risk or decreasing capital charges. These “balance sheet CDOs” tend to be structured with leveraged loans as the primary source of collateral. The second motivation is to take advantage of the yield differential between the assets in a CDO portfolio and the cost of funding the CDO. These “arbitrage CDOs” typically use a much wider range of collateral including a combination of leveraged loans, high-yield bonds, asset-backed securities, investment grade corporate bonds and even repackaged tranches of previously issued CDOs. CDOs offer investors the opportunity to obtain exposure to several asset classes which many investors may find difficult to analyse or manage. The structured nature of the CDO provides a security that benefits from credit enhancement, professional management of the collateral and a diverse portfolio, as opposed to risk concentrated in only one asset.

Assets It is the assets, more than anything else, that define a CDO. The general definition of a CDO is a securitisation of corporate obligations. By order of volume, CDOs comprise securitised commercial loans, corporate bonds, asset-backed securities (ABS), residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), and emerging market debt. Even tranches of CDOs have been resecuritised into CDOs of CDOs. Loans and bonds have made up the bulk of CDO collateral (see graph 1). Historically, these have been non-investment grade assets. The use of investment grade bonds and loans has grown, however. ABS, RMBS and CMBS have also increased and now comprise 9 per cent of underlying assets. CDO assets are more and more diverse globally. But CDOs do not always own these assets outright. Sometimes a CDO achieves exposure to these assets synthetically. In one common synthetic structure, the CDO purchases a credit-linked note that references one or more underlying assets. The credit-linked note is designed to mimic the risks of owning the underlying assets. If referenced assets default, the principal and interest due the CDO under the note is reduced via a specified computation. The credit-linked note’s coupon reflects the credit risk of the referenced assets as well as the note’s obligor. Typically, the issuer of a credit-linked note is exposed to the referenced credits by, for example, having made loans to the name. Any credit loss that the issuer sustains from its dealings with the referenced credit is offset by the reduction of its obligation under the credit-linked note. Because the CDO assumes exposure to the referenced asset without buying it, the issuer of the credit-linked note gets rid of credit risk without selling the asset. A CDO might have a few synthetic exposures or be comprised entirely of synthetic exposures. We estimate that 14 per cent of CDO exposures are produced synthetically, and this percentage is growing rapidly.

Tranches CDOs issue multiple classes of equity and debt that are tranched in order of seniority in bankruptcy and timing of repayment. The equity tranche, sometimes called junior subordinated notes, preferred stock or income notes, is the lowest tranche in the CDO’s capital structure. The equity tranche sustains the risk of payment delays and credit losses first to make debt tranches less credit risky. It receives whatever cash flows are left after the satisfaction of debt tranche claims. The table shows a typical CDO structure. In most CDOs, the top-most tranche provides the majority of the vehicle’s financing. Other debt tranches are sized around 5-15 per cent, depending on their number. Equity is generally around 2-15 per cent of the CDO’s capital structure, depending on the credit quality and diversity of the assets. The first loss protection of an equity tranche can also be created synthetically outside the CDO structure, for example, by the terms of a credit-linked note. Reduction of principal and interest on the note might occur only if losses on referenced assets exceed some set amount. This first loss carve out might be expressed on a per-name basis (losses up to $X per name) or on an overall portfolio basis (losses up to $X across the entire portfolio). In the language of insurance, the issuer of the credit-linked note has to meet a deductible before being able to make a claim via reduced payments on the credit-linked note. Subordinated CDO debt tranches protect more senior debt tranches against credit losses and receive a higher coupon for taking on greater credit risk.

Use of new collateral In the past few years, CDOs have increasingly looked at different assets to use as collateral for new issuance. This is a natural extension of a growing product line but it is also a likely result of a limited amount of supply in more traditional CDO collateral classes (such as high yield bonds, subordinated classes of ABS). One sector that has begun to show promise in this market is the hedge fund or fund-of-funds CDO; another is distressed debt CDOs. Hedge fund CDOs Hedge fund managers use CDOs as a funding vehicle for several reasons. Securitisation of hedge funds can provide a diversified source of funding and give the fund a term-financing option. It can allow a hedge fund to increase assets under management because it can move assets into a CDO and still manage them. And CDOs may provide an attractive cost of funding for a hedge fund. Hedge fund CDOs may interest investors for several reasons. They can provide access to investment strategies and products that may not be available in more traditional investment products. Some hedge fund strategies may have impressive long-term track records of outperforming broad indices on a risk-adjusted basis and may be attractive to investors of more traditional products on that basis. And many hedge funds are given greater discretion in their investment parameters than investors may be able to achieve in other market sectors. Fund-of-funds strategies, which use a number of different hedge fund styles and managers, are often more desirable for CDO structures. The fund-of-funds concept leverages the core concept of a CDO in that it avoids the risks of exposure from a single manager. The structure increases diversification, minimises style or manager risk and usually employs an institutionalised selection process of managers. As in more traditional CDOs, the collateral in a fund-of-funds CDO must meet several general parameters. These may include limits on the amount invested in any single manager, fund or investment strategy. Distressed debt CDOs High yield bonds and leveraged loans have reached record levels of defaults in the past few months. As a result, the idea of a CDO collateralised by distressed debt is timely. This ability may be useful to an issuer for two purposes: to remove distressed debt from a balance sheet or to take advantage of distressed pricing levels and benefit from the arbitrage through the CDO market. Distressed debt CDOs are similar in many ways to high yield CDOs. However, since the assets are already in default – or are trading with dollar prices that are considered distressed levels – the key factor in structuring these CDOs is the determination of the appropriate level of credit enhancement. The rating agencies will look carefully at the assets in these collateral pools to determine an expected recovery rate, and these rates will drive the amount of credit enhancement that will be necessary to achieve the desired ratings across the tranches of the deal.

Purposes CDOs are classified as either balance sheet or arbitrage CDOs, depending on the motivation behind the securitisation and the source of the CDO’s assets. Balance sheet CDOs are initiated by holders of securitisable assets, such as commercial banks, which desire to sell assets or transfer the risk of assets. The motivation may be to shrink the balance sheet, reduce required regulatory capital or reduce required economic capital. The most straightforward way to achieve all three goals is a cash sale of assets to a CDO. But, for a variety of reasons, the risk of the assets might be better transferred synthetically. This method can reduce required capital but cannot shrink the balance sheet. Nevertheless, we refer to synthetic CDOs that are done to adjust required capital as balance sheet transactions. Arbitrage CDOs, in contrast, are inspired by asset managers and equity tranche investors. Equity tranche investors hope to achieve a leveraged return between the after-default yield on assets and the financing cost due to debt tranches. This potential spread or funding gap is the arbitrage. The asset manager gains a management fee from monitoring and trading the CDO’s assets. An arbitrage CDO’s assets are purchased from a variety of sources in the open market. The asset manager typically invests in a portion of the CDO’s equity tranche. There is generally more trading in an arbitrage CDO than in a balance sheet CDO, where trading is typically limited to the replacement of amortised assets. A distinction that is commonly drawn between balance sheet and arbitrage CDOs ignores the fact that the asset seller in the latter also enjoys potential arbitrage profits from retention of the equity tranche. After the transaction is closed, the economic position of an equity investor in CDO that buys assets in the open market is not much different from that of the equity investor in a CDO that buys assets which the equity investor originated.

The Á la carte CDO menu Assets

High yield corporate bonds

Commercial and industrial loans

Emerging market corporate and sovereign debt

ABS, CMBS, RMBS and other CDOs

Investment grade debt, distressed securities, equity

Assets can be purchased or exposure can be gained synthetically Liabilities

Different number of tranches possible

Sequential, fast/slow or contemporaneous pay-down of principal

Coupons can be fixed rate or floating rate

Variety of portfolio tests to divert cash flow from subordinate to senior tranches

Delay draw tranche possible

Revolving tranche possible

Guarantee by third party possible Purpose

Balance sheet transaction:

A seller desires to shed assets to shrink its balance sheet and adjust economic and regulatory capital. Existing assets are transferred to the CDO and the seller takes back the CDO’s most subordinate tranche

Arbitrage transaction: A money manager wants to expand assets under management and equity investors desire non-recourse leverage. Assets may be purchased over warehousing and ramp-up periods

Origination transactions: (not a recognised term) Underlying CDO assets are issued specifically for a CDO Credit structure

Market value:The haircut value of CDO assets is periodically compared to CDO tranche par. If haircut assets are less than tranche par, CDO assets must be sold and tranches repaid

Cash flow:CDO subordinate tranches are sized so that senior tranches can survive asset default losses. If portfolio quality deteriorates, asset cash flow may be redirected from subordinate tranches to senior tranches

Credit structures A CDO can have either a market value or a cashflow credit structure, depending on the way the CDO protects debt tranches from credit losses. In a market value structure, the CDO’s assets are marked to market periodically. The mark-to-market value is then reduced (haircut) to take into account future market value fluctuations. If the haircut value of assets falls below debt tranche par, CDO assets must be sold and debt tranches must be repaid until haircut asset value once again exceeds debt tranche par. In contrast, there is no market value test in a cashflow CDO. Subordination is sized so that after-default interest and principal cash flow from the CDO’s asset portfolio is expected to cover debt tranche requirements. A common cashflow structuring technique is to divert cash flow from subordinated tranches to senior tranches if the quality of CDO assets diminishes by some measure. However, while the manager of a troubled cashflow CDO can sell CDO assets and the senior CDO obligation holders can sell CDO assets after a default, there is never a requirement to sell CDO assets. Nine out of 10 CDOs, both by number and volume, use the cashflow structure.

CDO spreads CDO spreads across the capital structure are shown below. At the upper end of the capital structure, spreads have been relatively stable for some time, even as the broader markets have been affected by a weakening economy and increased global volatility. Lower rated CDO tranches have been more negatively impacted, as they are closer to potential losses from collateral defaults However, deals that are being structured in today’s market of historically wide collateral spreads should benefit from the additional credit enhancement provided by these excess spreads. Thus, the increased market volatility and rising corporate defaults translate into cheaper CDO collateral and this produces structures with greater credit enhancement for the long-term investor.