The arbitrage collateralized debt obligation investor-type may still be a baby in Europe, but it’s poised to hit a growth spurt.
According to ratings agency Fitch IBCA, which last week published the first rating methodology for European arbitrage CDOs, at least seven or eight transactions are expected this year compared to only one last year, the Eurocredit CDO launched in August by ICG.
Invesco launched the first pure high-yield CBO in October, and Morley Asset Management launched the Global High-yield Bond Trust in March.
Also in the works are deals by DWS, with parent Deutsche Bank; and Mercury Asset Management, with parent Merrill Lynch. French insurance giant, Axa, is also said to be launching a euro CDO being lead and structured by Goldman Sachs.
The bulk of the expected launches should come this summer, said Markus Schaber, a director for Fitch.
“This market definitely is going to grow in Europe, a lot of the managers really want to leverage up exposure to high-yield,” Schaber said. “High-yield market CDOs will obviously become a large buyer of high-yield in Europe. You’re going to see more investor demand for the high-yield market in Europe.”
Investors and other sources agree that the demand is there, however the problem lies the amount and diversity of issuance in the European high-yield market and, until recently, in high bond prices.
“Everyone is doing it as soon as they possibly can, but the issue is diversification,” said Stefan Michel, a high-yield portfolio manager with Green T Asset Management.
Indeed, both DWS and Mercury had hoped to launch in the first quarter of the year. And a couple of sources said that the seven or eight cited by Fitch, especially if the bulk are supposed to launch during before the end of the summer, seems overly optimistic.
“The market is not to the point where there is enough issuance to fulfil the demand,” said Frank Benevento, executive director of high-yield capital markets for CIBC World Markets. Still, “there are some industrial issues coming to market before the summer lull.”
Structuring a CDO around European high-yield can be difficult. However, to combat the issue of diversification, CDOs and CBOs can use a number of strategies including mixing asset classes (possibly adding emerging markets or triple-B bonds) giving themselves a long ramp up period and investing in sterling and dollar high-yield products, said Brian McManus, head of CBO research at Merrill Lynch.
“They can use a credit derivative or buy them outright and use a currency swap,” McManus said. “Until the market is completely developed, they’ll be looking for those kind of solutions, using a little imagination to fill in the gaps.”
For example, as well as including U.S. high-yield bonds in its Global High-yield Bond Trust, Morley in March introduced equity. The CDO, launched with Warburg Dillon Read will invest roughly 15% in equity.
Eurocredit, on the other hand, used a combination of euro denominated bonds, leveraged loans and mezzanine debt to achieve diversity.
Aware of the diversification problems, Fitch has adjusted its rating requirements for European arbitrage CDOs. Traditional CDOs have been required to diversify their portfolios across as many as 20 different asset classes. However, Fitch believes because high-yield securities are not issued in all industries, this diversification requirement could force managers into sub-performing asset categories or categories where they don’t have significant experience. For that reason Fitch’s requirements for European arbitrage CDOs are generally limited to no less than ten sectors.
Fitch also allows for the use of more than one currency, although the agency strongly suggests that currency risk be hedged to the maximum extent possible.
In general Fitch’s rating process considers the capabilities of the portfolio manager and the probability of default, assesses recovery and recovery timing and looks at model and stress cash flows.