Collateralized debt obligation dealers are scrambling to restructure new deals by enhancing protection and possibly excluding junk note tranches altogether in an effort to appease finicky mezzanine investors. The unprecedented amounts of corporate downgrades and defaults are making mezzanine notes the toughest pieces of a deal to sell, CDO structurers say. Mezzanine tranches are the triple-B or double-B rated notes between the equity piece and the senior tranches. They do not have the upside return potential of the equity while taking on first losses as the bottom debt tranche. "It is a hard sale to place the mezzanine piece," admits Russell Hurst, director structured debt research at Banc One Capital Markets.
Anthony Thompson, head of CDO research at Deutsche Bank, says that "turboing," or diverting some of the excess spread from the equity to pay additional principal down into the structure, is beginning to make more and more sense. A CDO investor credits rating agencies for pitching those structural enhancements to the market (BW, 7/22). One CDO investor with a large insurance company says that there is talk in the market about structuring the mezzanine piece of high-yield CDOs or collateralized loan obligations with only one triple-B rated tranche, skipping the junk notes. He adds that the model for that is asset-backed securities CDOs or investment-grade CDOs, which typically never had double-B or single-B pieces. Banc One's Hurst says dealers are also looking to increase the size of the equity piece in order to provide more cushion for the mezzanine holders.
A CDO banker says that over the past two weeks, mezzanine note spreads on corporate bond-backed CDOs have widened by 50 to 100 basis points. In contrast, senior note spreads have widened 20 to 30 basis points. During the same period, mezzanine spreads of asset-backed CDOs have widened by 75 to 100 basis points, versus 20 basis points for the triple-A rated tranches. A CDO buysider says distress is even greater in the secondary market where mezzanine pieces can trade as low as 20 cents on a dollar, versus 90 cents for senior notes.