Structurers Add Twists In Hunt For CDO Yields

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Structurers Add Twists In Hunt For CDO Yields

Lehman Brothers and Banc of America Securities are marketing collateralized debt obligations with an option to extend the traditional five-year maturity.

Nik Khakee

Lehman Brothers and Banc of America Securities are marketing collateralized debt obligations with an option to extend the traditional five-year maturity. Meanwhile, structurers of cash-flow CDOs, which may also include credit-linked notes, have started allowing junior liabilities in the capital structure to be paid down early, in addition to super senior pieces. This has the dual benefit of reducing some of the costs of outstanding liabilities and attracting investors to different parts of a deal, firm officials said. Investors may be able to pick up yield by extending the maturity of a CDO to seven years, for example, because of the steep credit curve, according to Nik Khakee, director at Standard & Poor's in New York. From a ratings agency perspective, however, the challenge comes in determining the likely path of a default and calculating how much the probability of default increases in the extended period. "This is not obvious," he noted. The agency recently started receiving proposals for structures that offer protection sellers the option to extend the maturity of deals, he added.

Most of the extendable CDOs hitting the market are five-year structures with one or two-year call options that allow protection sellers to extend deals by this period, noted one official. Another strategy is for protection sellers to pay upfront for an option that buys them the right to be placed into a structure six-months later for a set coupon, he added.

In the deals that pay down various tranches of the CDOs, some dealers, including Citigroup Global Markets, are now also paying down lower tranches whereas it used to be only the most senior pieces would be repaid early. Officials at Citi declined comment. Lower-placed liabilities, such as mezzanine assets, may be more costly than senior ones and paying off these higher coupon liabilities earlier in the deal can give managers more flexibility, Khakee noted. One structurer added that getting back a quicker return on capital might also entice mezzanine investors who are concerned that they are taking on similar risk profiles to equity investors but are not being rewarded commensurately. "Super senior tranches practically fly out of the door, but placing mezz tranches has been brutal," the structurer noted.

These innovations are part of an effort by structurers to achieve higher returns because many are struggling to bring full capital structure deals to market due to tight credit spreads. Other strategies gaining momentum include writing options on synthetic structures that allow buyers of the deals to earn carry while they are waiting for spreads to widen (DW, 3/7). Hybrid deals that encompass assets, such as interest-rates, are also being evaluated to offer higher returns and different pay out profiles (DW, 3/14).

 

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