Structurers are circling distressed asset-backed debt as the next asset class for inclusion in collateralized debt obligations. The commoditization of multi-sector CDOs and a dramatic tightening in triple-B asset spreads over the last six months is prompting originators to look down the credit ladder in a bid for yield, according to structurers and rating agency officials. The market's bias toward innovation is also pushing the envelope. "The whole concept of distressed ABS is getting a lot more play; you can buy it very cheaply and it's still the senior tranche in the deal so you're entitled to all the cash flows," said Richard Gugliada, managing director and head of the global CDO group at Standard & Poor's. He said it has received a handful of inquiries about using distressed assets in CDOs but declined to name managers.
Beyond just the arbitrage incentive offered by securities offering high yields, deals of distressed ABS would constitute an entire new asset class. "The underwriting and structuring approach is different relative to performing assets. There is less certainty around the timing of cash flows and the amount of cash flows," said David Czerniecki, senior managing director at XL Capital Assurance. He said it has received inquiries about providing a wrap on such a deal. "There's a newness in terms of structuring, which is something that plays well for monolines," he explained.
A CDO of distressed ABS would be interesting if a manager could acquire assets at deep discounts and get enough diversity, according to one banker, who added, "There could be a huge amount of juice for the equity." For example, he said a distressed CDO senior that is trading at $0.60 on the dollar could offer a yield of LIBOR plus 150 basis points, which would help generate very attractive returns for noteholders.
Of course, there are some potential pitfalls associated with buying distressed assets. The lesson of the CDO market, according to one analyst, is that CDOs perform best when stable underlying assets are selected by managers who have expertise in a given area. Deals backed by CDOs of less-stable assets are more likely to underperform, he noted. That being said, with more and more information indicating that the credit cycle is headed for a benign turn, he predicted a CDO of distressed ABS would likely be able to tempt buyers.
