Bankers are kicking the tires on new ways to apply collateralized debt obligation methodology to untapped parts of the debt market, leading industry professionals to expect a handful of innovative transactions to surface in the coming months.
Last year's booming market for new issues--$73 billion in U.S. CDOs were sold, 40% up over the previous year, according to Deutsche Bank figures--is proving to be somewhat of a double-edged sword, according to market professionals. They say it shows the investor base is widening for CDOs and the memories of poor performance seem to be fading. But, this has the undesirable effect of more managers chasing ever-scarcer assets. And by a CDO's nature, the larger the demand for the underlying collateral, the tougher it is to construct deals with attractive rates of return.
As a result, bankers are looking to open up areas of the market that remain underdeveloped. Case in point: the trust preferred sector, which is likely to see deals backed by trust preferred securities from new types of financial institutions, such as real estate investment trusts. "I can't go into specifics, but we have looked at two or three different, similar concepts," said Sajjad Hussain, director at Fitch Ratings in Chicago, referring to extensions of the trust preferred method. He confirmed the use of trust preferreds issued by REITs are one of the possible innovations. The structures were first sold a few years ago with bank collateral before moving to include obligations from insurance companies and finally last year, hybrid deals. "There's not enough of a certain type of collateral out there, so rather than five or six different issuers fighting over this small remaining pool, a lot are thinking of other ways to apply the technology to other areas," Hussain said.
REITs, in particular, would seem to make the most sense, said one sell-sider. He noted there is no shortage of REIT trust preferred paper, especially since several sub-prime lenders (and well-known issuers) including New Century Financial converted to REIT status last year. He speculated it might make sense to use names that are familiar to investors in any new structures, although he noted it would not be a clean fit since these REITs are large and the trust preferred structure has to date used obligations from small and mid-sized borrowers. He asked, "The question is, is there enough of a viable market to justify the expense of creating a new asset class?"
Beyond just the usual incentives to innovate, bankers said they are looking at new collateral because tight spreads have created a real need to find new assets. "I do think there are other applications of the technology, it's just a matter of making it work," said one banker.
