Market Value CDOs: A Snapshot
Market value (MV) CDO assets are frequently marked-to-market, unlike cashflow CDOs. Credit opportunity funds have grown out of the traditional MV structure and are one of the more common vehicles in this market today. MV structures have increased in popularity after a drought for several years because they don't force managers into a long-only strategy and allow increased flexibility to generate alpha. Structural changes have made contemporary deals more viable and recent structures are either using significantly fewer illiquid assets, through credit opportunity funds, or keeping a large illiquid bucket and reducing leverage though a leveraged registered investment company.
Manager Selection
It is important to note that MV CDOs are more difficult to manage than cashflow structures. Managers must be able to optimize their portfolio to minimize market price volatility, which is usually not relevant to cashflow managers. They must also be able to navigate the additional "dimension" of managing the liability side of the deal balance sheet by adjusting leverage and/or invested capital. For example, higher leverage may be appropriate for liquid assets, while lower leverage may be appropriate for risky or illiquid collateral.
Likewise, it may be prudent to reduce invested capital when market opportunities are scarce. Managers may "self mark" a small number of assets in the portfolio. If there is a past history, investors should look at these "self mark" levels relative to actual execution prices to assess accuracy. Obviously, investors should look to past performance (both in seasoned MV CDOs and in total return portfolios) as an indicator of manager ability. Finally, since managers have the option of injecting equity capital to avoid an event of default, ability/willingness to raise capital for this purpose is also a consideration.
Typical Capital Structure
There are several significant changes in current MV CDOs relative to older vintages. The top of the capital structure now has more subordination, and receives an AAA rating (the highest rated tranches in older structures were generally rated AA). At the bottom of the capital structure, lower rated tranches seen in older structures, generally rated single-B or BB, have been replaced with a larger equity tranche, which often exceeds 20% of the capital structure. This change reduces leverage and increases return stability, albeit at the expense of lower expected returns.
Performance
Like other structured credit assets from the 1998-2000 vintages, MV CDOs suffered downgrades in the credit market downturn that followed. Although downgrades were similar to the Cashflow CDO experience, most bonds were ultimately repaid in full. Fitch Ratings, which has rated the largest number of MV CDOs, reports that performance over the last few years has been positive as the value of collateral securities has risen. The agency notes that upgrades in 2004 were the result of strong collateral performance, and deals that are not already liquidating have substantial OC cushion or have made generous equity distributions over the past year. The agency cautions, however, that additional price improvements are unlikely in current market conditions and assigns a stable rating performance to this sector for 2005.
Spreads and Relative Value
Recent MV CDOs have priced wider than Cashflow deals, and with the MV CDOs in a period of price discovery, there is a potential opportunity to find strong relative value. In particular, we think that Senior MV CDOs (AAA, AA) have a similar to lower risk profile versus Cashflow CDOs, making the spread-pick up on these bonds attractive. We are more balanced in our view on of Mezzanine and Equity notes, and recommend a Neutral allocation.
Structural Variations: Leveraged Registered Investment Company (RIC)
A leveraged RIC under the Investment Company Act of 1940 (40-Act) is another twist to the MV CDO structure. These vehicles share many features with the MV CDOs but have several differences. Special Value Opportunities Fund, LLC (SVOF), a 2004 transaction managed by Tennenbaum Capital Partners, is one example. Leveraged RICs generally have only one class of notes above the common shares rather than multiple tranches with different levels of seniority.
These structures also tend to have longer lock-up periods and higher exposure to illiquid assets. We expect to see more of these structures in the near future, as managers look to lock in new longer term financing at currently tight spreads.
This week's Learning Curve was written by Christopher Flanagan, Benjamin Gravesand Rishad Ahluwaliaat JPMorgan's Global Structured Finance Research team in New York and London.
