Structures of new collateralized debt obligations are not as strong as they used to be, says Mirja Wenski, portfolio manager at ZAIS Group Investment Advisors in Dublin. Deals are becoming less investor-friendly because tight credit spreads have forced crossover investors to look to the CDO market for higher yields, and they are less demanding of protections that experienced CDO buyers tend to require. "These weaker structures are bad for investors and we will see more defaults," Wenski warns.
Three or four transactions that include weaker structural features have already come to market in the first quarter of the year, says James Hart, another portfolio manager at ZAIS. He declines to name specific offerings.
For example, obligor limits, especially in mezzanine loans, are creeping up, which is leading to less diversification among the underlying names. Also, documentation on new deals is increasing the flexibility afforded to managers to purchase assets at steep discounts, which also increases risk. "Both of these developments mean that weaker assets are finding their way into CDO structures," Hart says. As a result, ZAIS is being more selective in which deals it participates in, he adds.
Others agree that investors are relaxing their credit standards. "We're seeing a decline in structural protection, higher leverage and weaker issuers getting deals done," says Sohail Rasul, managing director at monoline XL Capital Assurance. "We are not seeing downgrades and defaults yet, but we are starting to see models declining more deals," he adds.