Hedge funds are starting to forgo managing collateralized debt obligations of structured finance securities, according to market officials. Tighter collateral, particularly in the subordinate classes, is erasing arbitrage and making it less attractive for hedge funds to issue. At the same time, traditional managers, such as Putnam Investments and TCW Asset Management, are still trying to sell CDO liabilities despite tighter collateral spreads.
The trend is noteworthy because hedge funds were some of the first to embrace multi-sector collateral as a viable asset to be repackaged in a CDO structure. Typically run by former sell-siders with credit-intensive backgrounds, hedge funds emerged as a natural collateral manager base for CDOs. But, the recent run-up in some subordinate structured finance paper, especially in home equities, has left some managers holding profits. Fixed-rate, triple-B home equities have tightened by more than 200 basis points since September, while similar floating-rate securities were recently at their tightest level in more than five years, according to Deutsche Bank. And, given that hedge funds derive the bulk of their earnings from profits, not management fees, they are incentivized to realize gains and look elsewhere.
"The opportunity is not as compelling as it was, so I wouldn't be surprised if some managers decided to take their profits. We're exploring the possibility of other asset classes for our next deal," says Larry Penn, managing director at Ellington Capital Management, the sponsor of the Duke Funding transactions.
In fact, few new multi-sector CDOs have been announced since the start of the year. Analysts say this is because managers that have ramped up collateral are considering whether to liquidate their portfolios and take profits, or attempt to go ahead with a deal that is decidedly less attractive. They decline to name specific managers. "It's a business decision to do a CDO. They might say 'maybe we should liquidate because of the economics, but there might be other pressure to go ahead with the deal," speculates one sell-sider.
Traditional investors, however, are paid to increase their assets under management, meaning that even with the shrinking arbitrage it's in their interest to manage transactions. Putnam, for instance, is in the market with a $300 million transaction. Carl Bell, head of portfolio construction for CDOs, did not return a call and Mike Utley, a spokesman for TCW, did not return a call by press time.