Tuesday, December 28, 2004
CDOs in Asia
http://asia.news.yahoo.com/041228/5/1tt4f.html
Tuesday December 28, 15:04 PM
OUTLOOK 05: Asia To See New CDOs, In Different Shapes
By Shen Hong
Of DOW JONES NEWSWIRES
SINGAPORE (Dow Jones)--Fancy a CDO investment? Nah, been there, done that. CDS, then? Oh, please, that's so 20th century.
For 2005, Asia's restless investment bankers won't be satisfied selling such credit derivatives as plain old collateralized debt obligations. Fighting for new business as spreads on standard investments dwindle, they'll be pushing "CDO-squared," CDOs of leveraged loans and CDOs of ABS, all the while wowing clients with talk of subordination and fungibility.
Bankers scoff at what have become plain vanilla synthetics. "Even the man on the street would like to have the flavored ones nowadays - preferably with a bit of fungibility, because that's where the juice is," says one banker.
Behind all the hype is a salient fact about the region's burgeoning derivatives market: as they approach their fourth anniversary in Asia, CDOs are coming of age. And with the repackaged pools of bonds, loans or other credit products becoming more prevalent and the competition to sell them heating up, investment bankers must find more exotic offerings to keep the attention of hedge funds and other well-heeled clients.
A CDO is a collection of debt assets repackaged for sale as securities with different assigned risks. Originally backed by cash instruments such as bonds and loans, CDOs are now often synthetic - backed by more exotic products, such as credit default swaps (themselves derivatives that are essentially insurance against a debt issuer going bust).
Bankers usually structure a CDO in three tranches called - in descending order of credit rating - senior, mezzanine and equity notes. Regardless of the creditworthiness of the underlying assets, the senior CDO notes can have a high rating because the investors are shielded against the risk of default by the subordination of the tranches. Any defaults among the pool of assets in the CDO are first borne by the equity-note investors. Only when they are wiped out do the mezzanine holders take a hit. The senior tranche is affected only if the entire mezzanine tranche is depleted.
Equity notes offer higher yield than the safer tranches above them, to compensate for the higher risk, but even the highest-rated notes in a CDO structure typically offer higher yields than comparably rated corporate bonds.
For CDOs sold in Asia in 2005, strategists expect a shift in the nature of the underlying assets toward such products as lower-rated corporate loans and asset-backed securities - away from investment-grade bonds and loans, as returns on traditional credit products dwindle after a two-year bull run.
The biggest change in the product mix is likely to be the introduction of CDOs as the collateral for an even bigger CDO structure, an experiment that creative bankers have been trying worldwide in the past two years. These CDOs of CDOs, nicknamed "CDO-squared," usually take the form of a "master" or "mother" CDO pooling the mezzanine tranches of several "baby" CDOs. The issuer will then "re-tranche" the deal backed by these usually BBB credits into senior, mezzanine and equity portions.
"The main advantage of a CDO-squared is the yield because regular CDO spreads are already higher than underlying assets," said Gilbert Ong, associate director of international structure finance at Fitch Ratings in Hong Kong. "When you put together these high spreads, you will have even higher yields."
A banker at a large Singapore institution said that, although a CDO-squared could use either senior or equity tranches of other CDOs as reference collateral, "The mezzanine tranches are more popular because the yield pickup is there and such credits are benefiting from a benign credit cycle."
The mezzanine tranche of a regular CDO yields about 125 to 150 basis points over the London Interbank Offered Rate, while a typical CDO-squared comprising 10 to 20 baby CDOs would on average yield 200 to 250 basis points over Libor. "It's a return-driving product and hedge funds love it," said the Singapore banker.
What's also making CDO-squared popular is the "fungibility feature" - each baby CDO provides a separate layer of risk protection for investors in the mother CDO. Since the overall investment pools the mezzanine tranches of the smaller ones, the equity tranche of each baby CDO serves as a cushion against defaults by any of the underlying credits.
"For a CDO-squared that has five baby CDOs, for example, the first dollar of losses would usually hit the equity tranche of CDO one before its counterpart in CDO two, three, four, and five. And then it will get to the mezzanine tranches," said a banker at a European bank in Singapore. "It's basically this multi-subordination feature that is protecting investors."
There is a catch with this fungibility, though - the overlap risk that would occur if a problem credit is lurking in more than one of the baby CDOs. "If Parmalat appears in three out of five baby CDOs, you will get hit harder than usual," said Fitch's Ong, referring to collapsed Italian dairy giant Parmalat Finanziaria SpA. "That's the main disadvantage of a CDO-squared."
Aside from CDO-squared deals, plain-vanilla CDOs are also taking advantage of the improved macroeconomic environment by pooling riskier, higher-yielding assets. After their 2004 debut, CDOs of leveraged loans - packages of loans to junk-grade borrowers with ratings at BB or below - are expected to become another highlight of 2005.
Leveraged loans usually occupy a senior and secured position in a company's capital structure, and thus are blessed with stronger covenant protection for creditors. Despite the borrowers' sub-investment-grade ratings, the loans have lower default and higher recovery rates than corporate bonds.
A typical borrower might be a company be with sturdy fundamentals - say, a supplier for IBM. But because of its inferior ratings and the market's lack of liquidity, the company's leveraged loans offer much higher yields than other credit products, even in the current environment of rising interest rates. The yield on a BB borrower's leveraged loans is around 200 to 300 basis points over Libor, despite a sharp tightening for spreads on investment-grade bonds and loans in the past year.
The AAA trance of a typical CDO of U.S. leveraged loans would yield at least 35 basis points over Libor, while the riskier equity tranche could yield as much as 15% to 19%, said Victor Wee, executive director of the Asian Special Credit Group at UBS AG in Singapore.
"We have had a more vibrant leveraged-loan market in Asia this year, as banks are more open to places like Indonesia as more mergers and acquisitions take place," Wee said. "My sense is that next year in Asia, we are going to have global deals first, maybe 50% U.S. names and 50% Asian names. When we are ready, we may have pure Asian deals."
Such loans are expected to come from China and Hong Kong, the region's biggest providers of the product, while Indonesia and the Philippines are the fastest growing as their economies gather steam.
For more conservative investors, such as insurance companies, a potentially popular instrument in 2005 may be CDOs of asset-backed securities, which normally offer more price stability than corporate credits. Among CDOs of ABS, high-grade deals backed by ABS rated AAA or AA are becoming increasingly popular.
"Structured-finance deals like ABS CDOs also allow investors access where supply is limited in cash products like commercial mortgage-backed securities and residential mortgage-backed securities, despite a growing ABS market in Asia," said Wee at UBS.
Excluding Japan and Australasia, Asia issued $22.2 billion in new asset-backed securities in the first nine months of 2004 - running about 25% below the pace of 2003, when $39.6 billion worth were issued for the full year.
The fall is largely because of a drop in South Korean issuance, which accounts for the bulk of the total. Bad debt problems in the credit card sector - most previous Korean ABS were backed by card revenues - hurt issuance there this year. Excluding Korea, Asian ABS issuance totaled $5.52 billion for the nine months, more than the 2003 full-year total of $3.35 billion.
While it may be foolhardy to hazard a guess about what lies in store in 2005, one prediction looks safe: the Asian CDO lexicon will expand.
The next big thing to gain a foothold might be "CDO-cubed." This refers to a structure in which the underlying assets include one CDO-squared and several other regular CDOs.
"CDO-cubes?" asked the European banker in Singapore, as if surprised that the term needed explanation. "Well, you can multiply the CDOs as many times as you want, can't you?"
-By Shen Hong, Dow Jones Newswires; 65-6415-4046; hong.shen@dowjones.com
-Edited by William Mallard
Tuesday December 28, 15:04 PM
OUTLOOK 05: Asia To See New CDOs, In Different Shapes
By Shen Hong
Of DOW JONES NEWSWIRES
SINGAPORE (Dow Jones)--Fancy a CDO investment? Nah, been there, done that. CDS, then? Oh, please, that's so 20th century.
For 2005, Asia's restless investment bankers won't be satisfied selling such credit derivatives as plain old collateralized debt obligations. Fighting for new business as spreads on standard investments dwindle, they'll be pushing "CDO-squared," CDOs of leveraged loans and CDOs of ABS, all the while wowing clients with talk of subordination and fungibility.
Bankers scoff at what have become plain vanilla synthetics. "Even the man on the street would like to have the flavored ones nowadays - preferably with a bit of fungibility, because that's where the juice is," says one banker.
Behind all the hype is a salient fact about the region's burgeoning derivatives market: as they approach their fourth anniversary in Asia, CDOs are coming of age. And with the repackaged pools of bonds, loans or other credit products becoming more prevalent and the competition to sell them heating up, investment bankers must find more exotic offerings to keep the attention of hedge funds and other well-heeled clients.
A CDO is a collection of debt assets repackaged for sale as securities with different assigned risks. Originally backed by cash instruments such as bonds and loans, CDOs are now often synthetic - backed by more exotic products, such as credit default swaps (themselves derivatives that are essentially insurance against a debt issuer going bust).
Bankers usually structure a CDO in three tranches called - in descending order of credit rating - senior, mezzanine and equity notes. Regardless of the creditworthiness of the underlying assets, the senior CDO notes can have a high rating because the investors are shielded against the risk of default by the subordination of the tranches. Any defaults among the pool of assets in the CDO are first borne by the equity-note investors. Only when they are wiped out do the mezzanine holders take a hit. The senior tranche is affected only if the entire mezzanine tranche is depleted.
Equity notes offer higher yield than the safer tranches above them, to compensate for the higher risk, but even the highest-rated notes in a CDO structure typically offer higher yields than comparably rated corporate bonds.
For CDOs sold in Asia in 2005, strategists expect a shift in the nature of the underlying assets toward such products as lower-rated corporate loans and asset-backed securities - away from investment-grade bonds and loans, as returns on traditional credit products dwindle after a two-year bull run.
The biggest change in the product mix is likely to be the introduction of CDOs as the collateral for an even bigger CDO structure, an experiment that creative bankers have been trying worldwide in the past two years. These CDOs of CDOs, nicknamed "CDO-squared," usually take the form of a "master" or "mother" CDO pooling the mezzanine tranches of several "baby" CDOs. The issuer will then "re-tranche" the deal backed by these usually BBB credits into senior, mezzanine and equity portions.
"The main advantage of a CDO-squared is the yield because regular CDO spreads are already higher than underlying assets," said Gilbert Ong, associate director of international structure finance at Fitch Ratings in Hong Kong. "When you put together these high spreads, you will have even higher yields."
A banker at a large Singapore institution said that, although a CDO-squared could use either senior or equity tranches of other CDOs as reference collateral, "The mezzanine tranches are more popular because the yield pickup is there and such credits are benefiting from a benign credit cycle."
The mezzanine tranche of a regular CDO yields about 125 to 150 basis points over the London Interbank Offered Rate, while a typical CDO-squared comprising 10 to 20 baby CDOs would on average yield 200 to 250 basis points over Libor. "It's a return-driving product and hedge funds love it," said the Singapore banker.
What's also making CDO-squared popular is the "fungibility feature" - each baby CDO provides a separate layer of risk protection for investors in the mother CDO. Since the overall investment pools the mezzanine tranches of the smaller ones, the equity tranche of each baby CDO serves as a cushion against defaults by any of the underlying credits.
"For a CDO-squared that has five baby CDOs, for example, the first dollar of losses would usually hit the equity tranche of CDO one before its counterpart in CDO two, three, four, and five. And then it will get to the mezzanine tranches," said a banker at a European bank in Singapore. "It's basically this multi-subordination feature that is protecting investors."
There is a catch with this fungibility, though - the overlap risk that would occur if a problem credit is lurking in more than one of the baby CDOs. "If Parmalat appears in three out of five baby CDOs, you will get hit harder than usual," said Fitch's Ong, referring to collapsed Italian dairy giant Parmalat Finanziaria SpA. "That's the main disadvantage of a CDO-squared."
Aside from CDO-squared deals, plain-vanilla CDOs are also taking advantage of the improved macroeconomic environment by pooling riskier, higher-yielding assets. After their 2004 debut, CDOs of leveraged loans - packages of loans to junk-grade borrowers with ratings at BB or below - are expected to become another highlight of 2005.
Leveraged loans usually occupy a senior and secured position in a company's capital structure, and thus are blessed with stronger covenant protection for creditors. Despite the borrowers' sub-investment-grade ratings, the loans have lower default and higher recovery rates than corporate bonds.
A typical borrower might be a company be with sturdy fundamentals - say, a supplier for IBM. But because of its inferior ratings and the market's lack of liquidity, the company's leveraged loans offer much higher yields than other credit products, even in the current environment of rising interest rates. The yield on a BB borrower's leveraged loans is around 200 to 300 basis points over Libor, despite a sharp tightening for spreads on investment-grade bonds and loans in the past year.
The AAA trance of a typical CDO of U.S. leveraged loans would yield at least 35 basis points over Libor, while the riskier equity tranche could yield as much as 15% to 19%, said Victor Wee, executive director of the Asian Special Credit Group at UBS AG in Singapore.
"We have had a more vibrant leveraged-loan market in Asia this year, as banks are more open to places like Indonesia as more mergers and acquisitions take place," Wee said. "My sense is that next year in Asia, we are going to have global deals first, maybe 50% U.S. names and 50% Asian names. When we are ready, we may have pure Asian deals."
Such loans are expected to come from China and Hong Kong, the region's biggest providers of the product, while Indonesia and the Philippines are the fastest growing as their economies gather steam.
For more conservative investors, such as insurance companies, a potentially popular instrument in 2005 may be CDOs of asset-backed securities, which normally offer more price stability than corporate credits. Among CDOs of ABS, high-grade deals backed by ABS rated AAA or AA are becoming increasingly popular.
"Structured-finance deals like ABS CDOs also allow investors access where supply is limited in cash products like commercial mortgage-backed securities and residential mortgage-backed securities, despite a growing ABS market in Asia," said Wee at UBS.
Excluding Japan and Australasia, Asia issued $22.2 billion in new asset-backed securities in the first nine months of 2004 - running about 25% below the pace of 2003, when $39.6 billion worth were issued for the full year.
The fall is largely because of a drop in South Korean issuance, which accounts for the bulk of the total. Bad debt problems in the credit card sector - most previous Korean ABS were backed by card revenues - hurt issuance there this year. Excluding Korea, Asian ABS issuance totaled $5.52 billion for the nine months, more than the 2003 full-year total of $3.35 billion.
While it may be foolhardy to hazard a guess about what lies in store in 2005, one prediction looks safe: the Asian CDO lexicon will expand.
The next big thing to gain a foothold might be "CDO-cubed." This refers to a structure in which the underlying assets include one CDO-squared and several other regular CDOs.
"CDO-cubes?" asked the European banker in Singapore, as if surprised that the term needed explanation. "Well, you can multiply the CDOs as many times as you want, can't you?"
-By Shen Hong, Dow Jones Newswires; 65-6415-4046; hong.shen@dowjones.com
-Edited by William Mallard
# posted by Tom @ 10:23 AM 
