Increased trading activity of highly rated secondary collateralized debt obligation (CDO) paper is making placing mezzanine tranches much tougher. Indeed, two collateralized loan obligations (CLO) have been pulled in recent months after failing to sell the lower rated tranches, according to a CDO manager who is in the process of raising debt for a CLO deal. He attributed the difficulties to a recent glut of paper that is being sold in the secondary market, principally AAA tranches that are being sold at a discount. These can provide the yields of a mezzanine tranche, but are higher rated paper. Buyers include managers of CDOs of CDOs such as David L. Babson & Company, Zais Group and Coast Asset Management, which previously were major buyers of CLO mezzanine paper, the manager said. "Repackers" are less active on the new issue side as a result, contributing to "the worst market we've ever been involved in," the manager added.
One investor, however, said the issue is more complicated than simply yield. "First, the reality is that the market is telling us when we are issuers, that it will not finance portfolios of predominantly mezz paper," said Drew Dickey, a managing director at Babson. Secondly, recent structural developments to improve the selling of the AAAs, such as CCC haircuts in senior overcollateralization tests have increased the PIK risk of the mezz paper, he added. Thirdly, while the CDOs of CDOs are taking advantage of buying secondary paper, there is still the need to have current interest collection. Discounted tranches offer cash collection way in the future, but CDOs of CDOs need current income collection to pay their own interest expense, Dickey explained. Babson's newest CDO of CDOs, the Connecticut Valley Structured Credit CDO II contains 40% mezz tranches, which are almost entirely CLO paper.
Plus there is a potentially brighter future for CLO managers. "We are seeing traditional mezzanine CDO buyers, including both U.S. and overseas insurance companies, gradually return to the market," Dickey said.