After a thin year squeezed by a lack of high-yield issuance, a wave of junk collateralized bond obligations is poised to hit the market on the tails of strong new issuance. "The pipeline is ready to explode," according to buyside sources, says Brian McManus, CBO analyst at Merrill Lynch in New York, who is predicting about 25 new junk-backed structured products in the next one to three months. But that very flood of deals may drive up the price of junk and snuff out the fat arbitrage between the underlying assets and what the structures pay out to investors, argue other analysts.
Last year CBO issuance dropped from about $50 billion to $36 billion, according to McManus, mostly due to the paltry number of new issues. The CBOs that did get done were forced to tap older credits that often had looser credit standards, says a buyside CBO pro. The poor quality of the underlying assets in turn drove away many potential investors.
But in January alone, the junk market has experienced $1 billion in cash inflows buoyed by mutual fund cash inflows and the Fed funds rate cut. There has been high investor demand for new bonds, such as the McLeodUSA deal (B1/B+), which was upsized by $300 million to $750 million with the 11.375% notes of '09 trading at a premium of $105. "Now there are more buyers in the market, and if this happens, high-yield companies will issue more bonds. This could lead to even more CBOs in the market," says McManus.
But not everybody is sold. "If CBOs flood the market they'll be forced to use secondary market paper," says a CBO boutique analyst who worries that junk issuance won't be so robust.
Moody's Investor Service doesn't consider the influx of junk CBOs set to come this year as a new trend, but rather a continuation of the second half of last year fueled by the cheap price of junk bonds. Gus Harris, who heads up the CBO group for the ratings agency, says as new junk bonds are issued and the quality of the market improves, it will only raise the price of the bonds, making CBOs uneconomical to issue. "The volume [of upcoming CBOs] is a reflection of the attractive arbitrage opportunities," he says, but "once the arbitrage becomes too thin it won't be economical to do them any more." The arbitrage is the spread between what CBOs must pay for the underlying assets, and what they receive from investors of CBO bonds.