Vol 3 (2006) - Issue 1

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Bull Market Products - An Observation

An historic bull market for corporate credit appears to be drawing to a close. While the credit markets are still strong, it is likely that the next big move will be a tightening in the credit cycle. There is some debate as to when this will happen but I believe there is little doubt that it will, although may be not until 2006. When the wheel turns, liquidity will decline and marginal borrowers will have trouble finding financing, even on very tough terms. Spreads will widen and nominal interest rates will rise. This will create a test of some of the innovations that appeared during this bull market. These tests will challenge all of us who work in the area of corporate rescue, especially those of us who try to get consensual deals done with issuers in the public debt markets.
Among the bull market products there have been second lien notes, structurally subordinated holdco PIKS, credit insurance (including, incredibly, single-name insurance for high yield bonds), synthetic portfolios, Collateralized Bond Obligations (CBOs) and Collateralized Debt Obligations (CDOs). In general these innovations are positive. They bring more investors into the market, providing greater liquidity. They allow finer segmentation of risk, permitting investors to determine how much risk they are willing to bear. They also allow higher leverage, both for the investor and the issuer, and can lead to a separation between the providers of capital, the party actually bearing the risk, and the borrower. I believe that this may turn out to be a difficult problem for al of us.
For example, CDOs are an investment vehicle that has grown enormously during this bull market cycle. CDOs are pools of money invested in accordance with generally strict criteria – for example, credit quality (e.g. S&P, Moody’s or Fitch ratings), maturity, duration, industry, currency etc. After the manager has assembled the portfolio that fits the criteria, it is cut into tranches, generally according to risk, and the tranches are sold to investors. Hedge funds and insurance companies are very active as investors in these vehicles.
The most senior or least risky tranche generally gets an AAA rating. These appeal to investors looking for high-quality liquid investments that may return more than single-name AAA investments (insurance companies are interested here). As investors become more willing to accept risk (or are greedier for return-think hedge funds ) the credit quality deteriorates as we go down the financial structure until finally we reach the investors willing to bear the most risk. They are generally the first loss or equity holders in the CDO and their return is the last out- sometimes cynics refer to this as the ‘toxic waste’ .The sponsor of the CDO is usually an investor here, but they are also getting management fees and trading revenues. The manager is a fiduciary for the whole pool and has limited ability to trade- generally only to keep the pool in compliance with its criteria.
This is a wonderful innovation and has helped fuel the growth of the high yield bond and leveraged loan markets. It has brought new investors and deepened the market. It has also significantly separated the investor from the underlying investment. Does a buyer in the AAA tranche really care about the business challenges faced by, to pick just one industry in turmoil, the tier one auto supplier who represents 2% of the portfolio? Do the investors in the A tranche ? The investor in the BBB tranche or even the B tranche? Not in any meaningful sense. It is almost certain that none of them have visited the management and formed a judgement about its ability to successfully navigate the enormous changes facing the auto industry. This is compounded by the fact that the manager is not particularly motivated by the funds performance (other than its impact on his ability to arrange additional funds or if he owns a lot of equity).The ‘life’ of the structure is more important to him than its performance.