Bankers and investors alike are optimistic about the collateralized loan obligation and collateralized debt obligation markets in 2006. An increased interest in ABS-CDS helped drive the CDO market in 2005 and is expected to help increase interest in CDO-CDS next year. On the CLO side, 2005 saw many investors cross the pond and open up shop in Europe, a trend expected to continue as that market continues to be hot.
Bear Stearns predicts that the "new new" thing for 2006 will be CDS on CDOs. According to a bank research report, trading in the market only occurred sporadically in 2005 but an expected publication of a standard CDS on CDO confirm by the International Swaps and Derivatives Assocation will help develop the market. "This is a sector that is poised to grow in popularity next year," said Ranajoy Sarkar, an associate director and CDO and ARMS analyst at Bear Stearns. "The market, as of now, is not a very liquid one, although we have seen it find some legs over the past two to three months. In many ways we believe the growth of the CDO-CDS market will mirror the experience of the ABS-CDS sector."
Sarkar noted that standard confirms on ABS-CDS were only published around mid-year 2005 and since then an estimated $75-$100 billion of notional value has been traded in this sector. He said the dealer community is going through a similar exercise on CDO-CDS. "Once we achieve a degree of standardization on how these securities should be valued and traded, it will pave the way for liquidity in this sector to increase in leaps and bounds," he added.
On the CLO side, Fred Haddad, GoldenTree Asset Management's lead loan portfolio manager, anticipates that more investors may consider credit loan opportunity funds, which have a market value mechanism or structure which is based on the market value of collaterals as opposed to the pure interest arbitrage of a traditional CLO. Aside from the novelty of a new structure, he said, "The low price volatility of loans makes them ideal for market value structures as this tends to make the total return of such funds more predictable." GoldenTree has not issued a loan opportunity fund, but it does have credit opportunity funds that contain some loans along with other asset classes.
Sarkar said core credit fundamentals remain generally strong going into the New Year. He said the optimism about corporate credit, coupled with the CLO sector's history of steady performance through the last credit downturn, should continue to fuel demand for CLO liabilities and hold spreads tight over the medium term. "The parts of the capital structure where you might see some widening pressure would be at triple-B or lower rated tranches," he said. "Investors may ask, 'Is 475 or 500 bp over LIBOR for double-B CLOs enough compensation on a risk-adjusted basis, when similarly rated paper in sectors such as a subprime ABS are pricing anywhere from 350 bp to 700 bp wider?' The technical pressure may cause spreads to widen in triple-B and lower rated CLO tranches."
Europe should also continue to prove a popular destination for buysiders following the influx of firms in 2005. Last year Credit Suisse First Boston's Leveraged Investments Group (LIG), a part of CSFB's Alternative Capital Division, set up a shop to manage leveraged loans, mezzanine debt and high-yield bonds. Highland Capital Management finalized its acquisition of ING Capital Management's (ICM) European loan business from ING Wholesale Banking in April. Babson Capital Management acquired Duke Street Capital Debt Management. The Carlyle Group completed its first European CLO in March and Eaton Vance opened an office in London in September. GoldenTree opened an office in June. "When I speak to other investment managers, some are there already and others are considering it. I think the trend of the larger players going over to Europe is going to continue," Haddad said.