U.S. bond managers, eager to generate steady fee income, quietly reaped an estimated $50 billion to $60 billion in assets from collateralized debt obligations issued last year.
And more are on the way. The fast-growing U.S. CDO market has $350 billion to $400 billion in outstanding debt, according to Anthony V. Thompson, managing director, securitization research, at Deutsche Banc Alex. Brown Inc., New York.
Despite American Express Co.'s widely publicized $1 billion write-off on its high-yield bond portfolio last year, a large portion of which was attributable to its CDO investments, many managers say the appetite for these structured finance products is growing.
Last year, Putnam Investments, MFS Investment Management, David L. Babson & Co. Inc., Capital Guardian Trust Co., Nicholas-Applegate Capital Management and Pareto Partners were among the firms that launched CDOs. Sources said other big-name firms, including Fidelity Investments, are planning to launch CDOs in early 2002.
"It is an effective way of getting substantial assets on your books," said Donald Mykrantz, director of fixed-income trading at MFS in Boston. The firm launched its second CDO in 2001, the Berkeley Street CDO, raising $300 million in assets. In 2000, MFS' first CDO, the Arlington Street CDO, also raised $300 million. Both CDOs are secured primarily by high-yield bonds, said Mr. Mykrantz.
For MFS and a number of bond managers, CDOs account for 2% to 3% of fixed-income assets under management. For Babson - a pioneer in CDO management - its $9 billion in CDOs represents 16% of the Cambridge, Mass., manager's total assets.
CDOs are securitized packages of higher-yielding fixed-income instruments, usually below-investment-grade bonds and bank loans, that are then divided into several tranches and sold to investors.
The attractions of managing the underlying collateral of CDOs are huge. For a $500 million CDO, a manager might need to raise, say, $25 million, to invest in the "equity" tranche of the deal. An outside investment bank will leverage that investment to $500 million, packaging the securities into several tranches and selling the senior notes and mezzanine debt to institutional investors. The underlying assets will be invested in some combination of high-yield debt, bank loans, investment-grade debt, mezzanine debt or emerging market debt for the life of the fund, generally seven to 10 years.
Fees on entire issue
The kicker is that the manager will rake in fees on the entire $500 million issue, even though the collateral might be just 5% of assets. And those assets won't disappear, regardless of performance; the manager will pick up fees for the life of the issue.
"The benefit for an investment manager is simple. ... if things work out, it's with you for a long time, unlike a pension account, which can hire and fire you every quarter," explained Gail P. Seneca, chief investment officer and managing partner of Seneca Capital Management LLC, San Francisco, which serves as collateral manager on several CDOs.
Fees tend to be richer than traditional bond portfolio fees, but not exorbitant. David Hinman, executive vice president and portfolio manager at Pacific Investment Management Co., Newport Beach, Calif., said PIMCO typically earns 40 basis points with a potential 10 basis-point performance fee for managing a CDO, compared with a roughly 35 basis-point fee for a $250 million separate account.
On the base fee alone, "we are getting five basis points more, and I would argue that they (CDOs) are twice as hard to manage," Mr. Hinman said. PIMCO manages $4.5 billion in CDOs. CDO managers must meet strict financial ratios, diversification requirements and minimum equity values to meet rating-agency requirements. A sharp increase in the default rate - as seen last year - can cause rapid deterioration in the portfolio. "These are not just portfolios that you throw up against the wall and they happen," said MFS' Mr. Mykrantz. "You have to manage them with many more constraints than a typical portfolio."
In most cases - with PIMCO being a notable exception - the manager keeps a portion of the equity tranche, which actually is a subordinated note, receiving the residual assets left after senior investors are paid off.
And that residual could be substantial - often resulting in 15% to 25% in annual returns. Senior note holders are paid off at the going interest for top-rated debt, meaning the equity tranche picks up the spread between the senior note and the underlying collateral - a difference that can equal 400 to 600 basis points.
Nor are managers generally put at risk because their equity stake often is paid from management fees. And sometimes principals of bond managers invest in the deals, or the tranches are included in a firm's deferred compensation plans. Many investors prefer the collateral manager own a piece of the equity because it aligns their interests, although Mr. Hinman argues that creates a potential conflict of interests since the manager could allocate better trades to the more lucrative CDO.
The equity tranche also is attractive to institutional investors - often insurance companies and banks - and high-net-worth investors. Relatively few large pension funds, endowments and foundations have invested in such tranches, although some say interest is growing.
"It would fit in the same space for an institution as a hedge fund," said Eric Oberg, global head of portfolio credit syndication with Goldman Sachs & Co., New York. Dan Lass, managing director of global marketing at Pareto Partners, New York, said nine different investors, including some unnamed U.S. pension funds, invested $15 million in the equity tranche of the firm's recent $280 million collateralized bond obligation, which is a type of CDO.
But the poor experience of many CDOs that originated in 1996 through early 1998 won't encourage a huge wave of pension-fund investment. The problem was that relative yields on high-yield bonds during that period were below the long-term average. Those lower-than-average spreads provided fewer investment opportunities and were compounded by the 1998 Russian debt crisis, said Stephen L. Nesbitt, senior managing partner at Wilshire Associates, Santa Monica, Calif.
Also, the default rate on high-yield bonds has roughly quadrupled in the past five years, throwing many early CDOs into trouble, said Tim Kasta, managing director at KMV LLC, a San Francisco-based quantitative credit risk research firm. According to Standard & Poor's, the high-yield default rate - now at 8.9%, up from 6.3% a year earlier - is the highest in 10 years. In addition, many CDOs from the mid-'90s were inadequately diversified, with too few issues and heavy reliance on telecommunications company bonds, Mr. Kasta said.
Wilshire is one of only a few pension consultants to recommend CDO equity tranches to its clients. A paper Mr. Nesbitt wrote a year ago said the equity tranche then offered an expected return of 25% after fees, higher than the 20% to 22% expected return for equity buyout funds with lower risk.
"I believe there is real interest in the general pension community to earn higher returns without taking an unwarranted amount of risk," Mr. Nesbitt said.
Other pension consultants report little interest by clients. Ted Disabato, president of Disabato Associates Inc., Chicago, said pension executives haven't been that enthusiastic about the concept. Louis Finney, investment consultant with William M. Mercer & Co. Inc., Chicago, hasn't seen much interest either, but said they could ultimately fill a niche in a pension plan.
However, demand from other investors is leading more bond managers to get into CDOs.
Putnam Investments, Boston, launched a CDO in 2001, the Putnam Structured Product CDO, its first since 1999. Sources familiar with Fidelity, Boston, said it has its first CDO in the pipeline, and it's expected to launch in early 2002. And consultants expect other large traditional money managers to join the fray in 2002. Dan Flaherty, Fidelity spokesman, said the firm had no comment on the subject.
The types of CDOs also are expanding. Real estate-backed CDOs started popping up in 2001, and Goldman Sachs' Mr. Oberg expects to see the first private equity and fund-of-funds CDOs.
David L. Babson is developing its first CDO backed by real estate debt for parent company MassMutual Financial, Springfield, Mass. The CDO is scheduled for issue in early 2002, said Drew Dickey, managing director at Babson.
But the price for failure is large. "The downside is that mistakes are very visible," said Alex Reyfman, credit derivatives strategist at Goldman Sachs. If the CDO doesn't perform, the money manager won't get investors the next time it looks to issue a CDO.