Struggling High Yield Market Gives Rise To New CBOs

While CBO volume continues to grow at a healthy pace, difficulties in the junk bond market have spawned the introduction of new structures this year in order to boost yields for both issuers and investors.

Since 1998, spreads on junk bonds have come in significantly, thus narrowing the high-yield/investment-grade differential that makes collateralized bond obligations so profitable to sell. And with rising defaults keeping a number of buyers at bay, CBO issuers have had to get creative, adding new asset types that offer higher yields to investors.

"In order to maintain arbitrage and keep the returns at a lucrative level, we've seen...more structures allow CBO mezzanine tranches as well as asset-backed mezzanine tranches," said David Tesher, structured finance analyst at Standard & Poor's Ratings Group, in a recent teleconference. Other new additions include REIT debt, commercial mortgage-backed and synthetic tranches.

According to one high-yield analyst, spreads have tightened to about 400 basis points over Treasurys from 494 basis points at the beginning of the year. Most of that occurred in the period from January to April, when spreads bottomed out at 370 basis points over; last fall, spreads were as high as 580 points over Treasurys.

Since CBO managers make money on the difference between junk bonds and investment-grade debt, spread tightening-generally viewed as a positive development-can often be devastating to these issuers.

Further compounding matters is the rise in high-yield defaults, which has led some investors away from CBOs. In fact, Tesher said a number of CBOs have experienced defaults and evaporation of credit support, leading to diminished returns.

"We've seen a pickup of defaults on high-yield bonds and loans, and certain structures and subordinate tranches have faced some difficulty," he said.

According to a report by Moody's Investors Service, high-yield defaults continued to rise in the second quarter of 1999. At the end of last month Moody's speculative grade, trailing 12-month default rate stood at 4.27%, compared with 3.3% at the end of December 1998.

True, that percentage isn't alarming, especially when remembering that default rates hovered around 10% early this decade. Nonetheless, a continued increase in defaults would make it difficult to structure these securities, Tesher said.

So far this year, S&P has rated 47 CBO/CLO transactions, at an aggregate amount of $25 billion. The 1999 total is on pace to exceed last year's total of 79 transactions, valued at $75 billion, by at least $4 billion.

"From the perspective of the market, 1999 continues to be a dynamic year in terms of CBO/CLO issuance," Tesher said. - Akil Roper