An increasing flow of low quality issuance has most market players expecting a wave of defaults and restructurings, presenting challenges for collateralized debt obligation managers. When credits starts to deteriorate, it is best to focus on a few situations that can be coaxed through for value rather than try to put out as many fires as possible, according to Jim Dondero, president of Highland Capital Management. "It pays to concentrate resources and focus on a few situations and ride those through the cycle," he said.
Dondero said that type of selective salvaging is one of the lessons learned from the firm's management of MLCBO4, which completed the call of all its debt last Monday. Highland manages about $16 billion in high-yield bonds, leveraged loans and asset-backeds and runs $7 billion in CLOs. But MLCBO4 was its first. Launched in December of 1996, it was also the first CLO structured by Merrill Lynch, which gave it a CBO moniker even though it was 80% loans. It ended up returning 185 cents on the dollar to equity investors after weathering two viscous credit cycles.
"When loans are around par, hyper diversification benefits structures," Dondero said. But when credits start to drop, it is time to start picking the ones with which to work. "Which two or three do we like, which ones have real recovery value and which ones do we think we can influence the outcome of?" Dondero said of Highland's approach.
The market is setting itself up for some stumbles, Dondero said. "Triple-C and single B- issuance is as high as it's ever been," he said. "It's a very logical expectation that defaults and restructurings will pick up." But the CLO business is chugging along. One investment bank's count had as many as 30 deals taking shape this month or shortly after Labor Day. Spreads are tight and supply is not great, but the right structures still work, Dondero said. "Assets spreads are low, but liability spreads have come in commensurately," he said. And his outlook for the credit markets? "I get paid to worry," he said. "I'm an optimist, but as far as credit goes, I'm always bearish."
