Returns on first-loss classes of collateralized debt obligations are creeping lower, spurred by the increasing use of high-grade securities as collateral and the sale of money market liability classes in asset-backed deals. Current transactions are offering equity returns in the low teens, with one deal even being marketed with a 10.5% return, according to CDO officials who declined to name specific deals. “Sub-11[%] would be the most aggressive print I’ve ever seen,” said one CDO pro. The narrower returns are a result of higher-quality collateral being used to structure short-term classes; given the underlying collateral yields less, equity returns are logically smaller, too. Yet the trend is also part of a maturation of the market whereby structurers are promising less, given that the equity classes of many of the first-generation CDOs have been wiped out.
Gary Witt, managing director and head of cashflow CDOs at Moody’s Investors Service and a former structurer at Prudential Securities, said the revolving nature of money market funding means that equity returns are likely to be lower. “They introduce a new variable into equity returns,” he said, referring to senior classes with maturities of 13 months or less, which is the traditional definition of a money market class. Since these classes are rolled over and re-sold based on current rates, expectations of higher rates means funding costs when the classes roll over will be higher--cutting into first-loss returns. “It’s another source of uncertainty from the equity’s perspective,” he said. That being said, money market classes can also potentially lower the cost of funding if they sell at tighter levels.
“It’s a great sign that the market is accepting more realistic and achievable returns,” added Jimmy Frischling, director and head of the CDO group at SG Corporate & Investment Banking. In the market’s infancy in the mid-to-late 1990s and during the stock market bull run, equity returns were marketed above 20%, he noted.