Dealing with default

Australia's retail investors have snapped up a wide variety of CDO investments over the past three years. But have the downgrades of Ford and General Motors, and the recent default of US auto parts manufacturer Delphi, soured investors' views?

It may be too soon to sound the all clear, but the signs are promising that Australia's collateralised debt obligation (CDO) market will emerge from this year's volatility in the US auto sector relatively unscathed. In other respects, however, the year has been an anti-climax for CDO issuers, as tight credit spreads have worked against new retail issues and led to a repricing of risk in the institutional market.

Arrangers have responded by improving their products, typically by introducing structural enhancements or diversifying the underlying reference pools. Innovation looks set to be a key theme for 2006.

Ratings agency Standard & Poor's (S&P) initially downgraded only two CDOs and put seven on credit watch in response to the downgrade of Ford and General Motors to junk status in May, noting that the concentrations of the two credits within underlying CDO portfolios were typically small. In October, the ratings agency downgraded eight synthetic CDOs and put another seven on credit watch after auto parts maker Delphi filed for bankruptcy.

One of these - Deutsche Bank's Nexus 3 notes, sold to Australian retail investors at the end of last year - has performed robustly since Delphi's default. "The Delphi position in Nexus 3 was senior secured and actually recovered 100%," says Ben Stammer, director, credit trading, at Deutsche Bank in Sydney. "So even though Delphi defaulted, there was no impact on the subordination, and Nexus 3 was actually upgraded after the full recovery on the Delphi position was confirmed." S&P had downgraded Nexus 3 from BBB+ to BBB after the volatility in May, and it is once again BBB+.

"For Delphi, as far as we know, the recovery rates have been very good," says Mei Lee Da Silva, head of structured credit at S&P in Melbourne. "At the moment, a lot of the deals containing Delphi are on 'watch developing' [by rating agencies]; depending on the recovery, the rating could be maintained or go up or down. We just have to wait until the recovery rates come in."

This uncertainty aside, the market is more relaxed than it was at a similar point in the aftermath of the Parmalat collapse two years ago. This is to be expected, given that the Parmalat failure, which involved fraud, was a much more severe and problematic credit event. The return to ratings health for many of the CDOs affected has taken time: S&P was still changing its ratings on Australian and New Zealand transactions earlier this year, a full 17 months after downgrading them.

Another reason is that Parmalat had a maturing effect on the market. It made investors - both retail and institutional - more aware of CDOs and their risks, and led to structural innovations designed to mitigate risk, or at least offer more ways of managing it. They include the use of portfolio managers - experts in global credit, who are better able than local investment banks to identify emerging problems - and 'combination' or 'combo' notes, which offer investors a credit play on a CDO's capital structure (Asia Risk December 2004, pages S4-S7).

These appeared during 2004 for the first time, and were in evidence again this year. In April, for example, Alpha Financial Products, a retail CDO arranged by ABN Amro, launched $55 million of seven-year combination notes, in which the principal was rated AA by S&P and the income was unrated. The components were referenced to two separate credit pools, both managed by Italy's Monte Peschi Asset Management.

"If you structure the transactions well enough, you can survive these things," says Moray Vincent, director of debt capital markets at Sydney-based broker Grange Securities. The firm has distributed A$1.4 billion ($1.02 billion) of CDOs, mainly to the institutional middle market (local authorities, charities, etc) since the firm's inception in Australia three years ago. "About 35% of total CDOs had Delphi in them, and that was about the same for us, but our CDOs were structured with sufficient robustness so that the effect of the Delphi default was minimal. We have a CDO called Ascot, which was rated AAA and which was unfortunate enough to have both Parmalat and Delphi in it. It's AA+ now."

More damaging than this year's credit events, however, were the effects of tightening credit spreads. Activity figures vary according to how the market is defined - some researchers, for example, group collateralised loan obligations (CLOs) under the CDO umbrella or exclude cross-border deals - but the market, by consensus, is well down on last year, and spreads are to blame.

In early November, S&P reported its year-to-date rated issuance by retail and institutional CDO/repack entities at just A$439.2 million compared with A$1.23 billion during the whole of 2004. The figures underestimate broad market activity, not only because they focus only on S&P rated transactions. The 2005 statistic, for example, excludes a $1.3 billion balance sheet CDO by National Australia Bank, launched in early November, which, although rated by S&P, was targeted at offshore investors.

Another measure of market activity, not comparable to S&P's, is that issuance in the retail sector alone this year - Australian-domiciled deals only, and including distributions from Macquarie Bank's Fortress CLO - totalled A$300 million, or half the A$600 million dealt in 2004. This was an informal estimate by CDO specialists at a major international bank. Put another way, only two domestic retail CDOs have been issued this year, with a third expected before the year-end. Even 2004's Parmalat-affected market managed to muster more retail transactions during the second half of the year. Whichever way the figures are cut, retail and institutional market activity clearly fell during 2005.

According to Deutsche Bank's Stammer, the effect has been fairly widespread across retail and institutional markets and different types of reference pools. "The sustained tightening in spreads has been most prevalent in the investment-grade credit default swaps market, which has affected CDOs in the Australian retail market. But to a lesser extent, that move in credit spreads has also affected CLOs and CDOs of US and European leveraged loans, and probably to a lesser extent the CDOs of asset-backed securities [in the institutional market]." Because of prospectus and other costs associated with retail issues, however, the spread tightening has hit retail new issues harder than institutional ones.

"It's difficult to compare [CDO] deals evenly because they're all quite different," says Paul Banks, Deutsche Bank's head of retail distribution. "It depends what tranche you buy, what the income is attached to and how the capital is treated. Broadly speaking, most trades in which retail investors are interested are priced between 200 and 400 basis points over the bank bill swap rate. It's difficult to see retail getting too excited, given the risks they perceive, for less than 200 basis points."

As with Parmalat, the market has stepped up to the challenge of tighter spreads by innovating. Deutsche Bank - which launched its first retail CDO in Australia in December 2002 - brought Nexus 4 to the market in May. The retail deal, formally known as Nexus 4 Topaz Notes, is the first listed CDO in Australia to feature a floating credit spread.

"Credit spreads had tightened to such a point that the market generally thought they would have to start moving out again," says Banks. "Having a floating credit spread gave retail investors the opportunity to benefit from any widening of credit spreads in the income they received."

Both Nexus 4 and ABN Amro's Alpha-managed income notes are aimed at retail investors. Both are structured as combo notes, and are at the long end of market maturities - seven years for Alpha, 10 years for Nexus 4. The principal component of the $50 million Nexus 4 is guaranteed by Deutsche Bank and is rated AA-, in line with the bank's credit rating. The coupon component is unrated. The underlying reference pool consists of 120 companies and is managed by Societe Generale Asset Management Alternative Investments.

The credit margin was set at 260 basis points over the 180-day bank bill rate for the first six months, after which it will be reset according to market credit spreads on the underlying portfolio. This arrangement will continue throughout the portfolio exposure period, after which the margin will be fixed for the remaining three years to maturity.

One of the supply side's earlier responses to lower credit spreads was to increase the leverage in transactions by, for example, issuing CDO-squared - transactions in which the reference pool consists of tranches of other CDOs. "These types of deals offered investors smaller amounts of single-name risk, but more general market risk," says Paul Cordeiro, head of structured credit at ABN Amro in Sydney. "They also had the benefit of maintaining the coupons of the previous generations of transactions. In the last six months, with the structural adjustment of the underlying tranche indexes, even CDOs of CDOs have been difficult to deliver in a saleable transaction."

In the institutional market, arrangers are responding by offering leveraged super-senior structures, which have proved popular in Europe but are only beginning to have an impact in Australia. "We've been involved in those trades for the past nine months or so, in deals placed here from offshore," says Deutsche's Stammer. "The leveraged super-senior market has really grown out of the great demand for investment-grade correlation trades from the AAA down to the BBB range, which has led to an imbalance in the correlation market, so that the super senior and equity tranches have had a lot more value. Leveraged super senior [transactions are] really trying to capitalise on that."

First of a kind

ABN Amro is currently marketing what is believed to be the first domestically structured leveraged super-senior transaction. Few details on the deal are available, but in general, the product gives investors a leveraged exposure to super-senior risk and pays a yield close to that on mezzanine tranches. The investor's exposure is limited to the initial collateral posted. To protect the dealer against gap risk - the risk that losses will exceed the investor's collateral - an unwind mechanism is embedded into the transaction that kicks in once the accrued credit losses within the portfolio reach a certain level, or the mark-to-market value of the trade hits a pre-determined barrier. Once an unwind trigger is breached, the trade unwinds at its mark-to-market value. Alternatively, the investor can post additional collateral.

"In a traditional CDO, if you have a credit event you have to cough up the cash and then you lose money," says Cordeiro. "In a leveraged super-senior transaction, technically speaking, you never have to lose one cent. If you get close to one of the triggers, or a trigger is exercised, you can simply add more cash to the transaction to deleverage." Portfolio losses would have to be very high under such circumstances to result in the loss of real money, he adds. "If you deleverage, you will get your money back at the end of the deal."

For Grange Securities' Vincent, constantly varying the style of deal offerings is a competitive necessity. "We try to differentiate each of our transactions from our last; not so much on price but on features. This year we've done a number of high-yield transactions as opposed to investment-grade ones." One of the firm's 2005 deals was an ethical transaction with a fund manager that selects credits on social responsibility grounds and manages it on that basis. Grange has also diversified its credit ratings, using Moody's Investors Service instead of S&P for its last two transactions.

ABN Amro has also targeted ethical fund managers. Earlier this year, it commissioned a corporate social responsibility rating from CSR rating agency RepuTex for its Rembrandt Australia Trust 2005-1 (Reef Series 1) transaction. Companies selected for the CDO received ratings ranging from A- to AAA, and the portfolio averaged A. As this article was written, the investment bank was marketing Alpha Multi Asset Rebalancing Securities (Mars). The deal, which will be the third domestically arranged retail offer of the year, is being promoted as the first CDO in Australia linked to a basket of energy, industrial metals, precious metals and emerging markets indexes.

Deutsche's Banks expects innovation to continue, regardless of levels of market activity. He believes that, having successfully addressed risks related to the principal side of the capital structure, Australian CDOs next year will look more at mitigating the correspondingly increased risk on the income component. "Nexus 4 was the first retail CDO in which income could move up or down. I think next year we'll probably see more CDOs that have a growth element in the income."