Klug is a senior collateralized debt obligation portfolio manager and head of the asset-backed/consumer finance team at Vienna-based UNIQA. He has managed the firm's ABS fund, R31, since October 2000. UNIQA is currently in the market with Stanton CDO I, a CDO-squared.
In terms of CDOs, what is UNIQA's investment philosophy?
It's pretty clear the overriding theme here is diversification and correlations. When creating a portfolio by buying individual tranches of CDO deals with different management styles, what you want to create is a master portfolio with exposure to different asset classes on a master obligor level. If you handle the exposures and the obligor diversification correctly, that creates an arbitrage for equity holders. You want a diversified portfolio to avoid having one big name default and creating a lot of stress in the various deals of the collateral pool. For example, we've avoided PIK-able tranches of high-yield bond CBOs, which have been the worst performers over the past few years.
What is the attraction/benefits of a CDO of CDOs structure?
The underlying collateral spreads in CDOs have tightened somewhat--mostly in investment-grade bonds and in high-yield bonds--not so much in leveraged loans. Liability spreads of individual CDOs are at historic and absolute wide levels, while the value of the underlying collateral has improved (lower market-implied default probabilities), making CDOs a good value at the moment. A CDO of CDOs should capitalize on further spread tightening in corporate debt instruments.
From an equity point of view, a CDO of CDOs has excess spread that is more stable, and the senior noteholders are earning good spread because of the higher liquidity and complexity premium. So, a CDO of CDOs can capture arbitrage from an equity point of view, and senior noteholders are getting, if you have a conservative capital structure and a seasoned manager, a stable investment.
What were investors most concerned about, in terms of the CDO market in general, during your roadshow for Stanton CDO I?
Everyone knows about the historic performance of CDOs, and investors were looking at our allocation to high-yield CBOs, especially older vintages, which we didn't have. Investors were also concerned about rating migrations especially with the amount of downgrades seen in the CDO sector.
In particular to Stanton CDO I, investors were concerned about the transaction's PIK risk and PIK probabilities in the mezzanine tranches of the deals we buy into and that comprise the CDO. Investors were interested in what kinds of analytical models we employ to actually assess the level of PIK risk in that kind of portfolio. Up to 75% of the CDOs in Stanton CDO I can be PIK-able securities, so if you have a lot of tranches PIK-ing at the same time, the interest income is lowered, which can impact the cashflows of the liability structure.
We jointly developed with Moody's KMV a model called CDO Analyzer that allows us to model the PIK probabilities of mezzanine tranches of CDOs. We up-load the collateral portfolios of individual CDOs into Moody's KMV Portfolio Manager, an extensive correlation model, and the CDO Analyzer uses a multi-period Monte Carlo simulation to calculate the cash flow distribution of each individual CDO tranche taking into account the underlying priority of payments and correlation of between the assets in the collateral portfolio. The PIK probability defines the likelihood of deferring for the tranche and triggering the over-collateralization test (OC Test) in the senior tranche--which would cut off cash flow from your equity tranche and stop interest payments in your mezzanine tranche. We believe this gives us a technological advantage as the Street is based on Intex or similar tool, ignoring the correlations in the underlying collateral pools.
What kind of structural elements did you include to make the deal attractive to investors?
We created two classes of triple-A securities--senior and junior. The senior is more for conduit investors and the junior triple-A class is for balance sheet investors. The deal also has a reinvestment OC Test that sits between the junior and second most-junior OC Tests. It stops cash from going into the equity portion, and frees up cash to invest in new collateral, which will bring the OC Test back into compliance with the notional balance in the deal. We also have a 15% annual cap on equity distributions. So, if we had equity returns of 17%, 2% of that would be used to buy additional collateral. Basically, anything beyond 15% will be reinvested in the deal.
Investors say they avoid CDOs in general not just because they are risky and haven't been the best performers, but because they already have corporate bond investing expertise in-house. How do you respond to that? What do CDOs offer investors?
Investing in a CDO is not the same as investing in a straight non-leveraged corporate or high-yield bond portfolio. With a CDO you have a capital structure and you have leverage, so the return and risk profile will be different. With a CDO of CDOs, the investor gets exposure to 30 to 40 collateral managers with relatively small investment. Also the risk profile of a CDO-squared is different to a CDO. If you buy a triple-B tranche in CLO and a triple-B tranche in a CDO-squared, there is lower risk in the CDO-squared tranche than buying outright a CLO or the underlying loan. In a CDO-squared, an investor has multiple layers of subordination that protect more from default. A CDO-squared's return is determined more by the correlation risk than single obligor defaults.
You can't compare structured credit with credit. In a corporate bond portfolio the manager is managing for defaults and market values, whereas in a CDO the biggest thing to manage is defaults, not the tracking error, relative performance or the yield curve.
Lately there has been criticism about CDO fee structures. What kind of fee structure does Stanton CDO I have?
On the structuring fee I think we are doing better than average. Normally, investors are charged between 1.8% and 2.4% for structuring and placement fees and we are below that range. Two-thirds of our management fees are performance-based. We're charging 45 basis points in total. Fifteen basis points is the base fee and the balance (30 basis points) is subordinated to all the rated notes. To get the 30 basis points we need to be in compliance with the OC Tests.
What kinds of innovations do you envision in the CDO market going forward? What is going to be the next big thing?
The market will move toward synthetic CDOs of ABS. CDOs of high-grade (double- and triple-A rated) ABS tranches are not efficient when fully funded because of the high funding costs. Also, investors are demanding more of an arm's length between the deals and the investment banks that usually manage/originate them. So, I expect to see more third-party asset managers managing these synthetic high-grade CDOs of ABS.
Another development I see going forward is synthetic high-yield CBOs, because the funding is more attractive or at least a combination of funded and synthetic. Using a synthetic structure, you don't need to go into lower tier high-yield names, you can go into double-B names. With low interest rates, fixed-rate high-yield bonds are trading at a premium or above par, which doesn't work for a cash CDO.