ssb the abcs of cdo equity

Glen McDermott(212) [email protected]

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G L O B A L

F I X E D - I N C O M E

R E S E A R C H

Structured Bonds

The ABCs of CDO EquityA Primer on Income Notes Collateralized byPools of Fixed-Income Assets

JULY 2000

GLOBAL

48163 abcs of CDO-final. qxd 6/29/00 15:25 Uhr Page 2

July 2000 The ABCs of CDO Equity

3

Executive Summary ............................................................................................................................... 5

Introduction 7

CDOs...................................................................................................................................................... 7

Cash Flow CDO Income Notes .............................................................................................................. 8

Return Analysis 13

Defaults .................................................................................................................................................. 13

Recoveries.............................................................................................................................................. 16

Interest-Rate Risk................................................................................................................................... 18

Call and Tender Premiums..................................................................................................................... 19

Collateral Manager 21

Collateral Manager Review.................................................................................................................... 21

Asset Selection....................................................................................................................................... 23

CDO Investment Guidelines .................................................................................................................. 23

CDO Manager Types ............................................................................................................................. 25

Investment and Trading Philosophy....................................................................................................... 25

Asset Characteristics 27

Collateral Mix ........................................................................................................................................ 27

Time Stamp or Cohort............................................................................................................................ 28

Diversification........................................................................................................................................ 29

Structure 30

Trigger Levels ........................................................................................................................................ 30

Senior Costs, Swaps, and Caps .............................................................................................................. 31

Manager Fees and Equity Ownership .................................................................................................... 31

Credit-Improved Sales — Treatment of Premium ................................................................................. 32

Conclusion 33

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4

FiguresFigure 1. Moody’s Rated Volume, 1988–1999 7Figure 2. Typical CDO Structure 8Figure 3. Historical Returns — Various Asset Classes, 1990–2000 9Figure 4. Correlation of Various Asset Classes, 1990–2000 10Figure 5. Principal Protected Units 12Figure 6. Historical Default Rate, High Yield Bond Market, 1971–1999 14Figure 7. Cash Flow Modeling Assumptions 14Figure 8. CDO Income Note Returns — Sensitivity to Annual Default Rates 15Figure 9. CDO Income Note Returns — Sensitivity to Default Rate Spikes 15Figure 10. Annual Recovery Rates, 1971–1999 17Figure 11. CDO Income Note Returns — Sensitivity to Recovery Rates and Annual Default Rates 18Figure 12. CDO Income Note Returns — Sensitivity to Recovery Rates and Default Rate Spikes 18Figure 13. CDO Income Note Returns — Sensitivity to LIBOR Movements 19Figure 14. Historical Calls and Redemptions (Dollars in Millions) 19Figure 15. Sensitivity to Call and Tender Premiums 20Figure 16. Collateral Manager Review Check List 22Figure 17. Portfolio Performance 22Figure 18. Typical CDO Investment Guidelines 24Figure 19. Nontraditional Assets 27

I would like to thank the following people for their insightful comments and assistance in thepreparation of this report: Dennis Adler, Timothy Beaulac, Adela Carrazana, Mark Lanzana,Adrian Lui, Heather Neale, Aaron Palmer, Gregory Peters, Melinda Prince, John Purcell, JanetSemper, Susan Seuling, Robert Snider, Janice Warne, Judith Watkins, Kyle Webb, and DarronWeinstein.


5

Cash flow collateralized debt obligations (CDOs) are formed when

asset-backed structuring technology is applied to a pool of

corporate credit exposures. A special purpose vehicle (SPV)

issues notes and uses the proceeds to purchase a pool of fixed-

income assets, which can include high yield bonds, leveraged

loans, and structured finance obligations. Since most of the issued

notes are highly rated, the CDO can raise a majority of its capital

cheaply in the investment-grade market and invest it more

profitably in other markets including the high yield market. The

cash flow CDO income note (or equity), which receives all residual

interest cash flow after payment of fees and rated note holder

coupon payments, is the main beneficiary of this lucrative

arbitrage. Traditional CDO equity buyers have included

sophisticated institutional investors such as banks and insurance

companies. We believe, however, that cash flow CDO income

notes represent a compelling investment for a broader audience

that includes pension funds and high net worth individuals. The

purpose of this report is to explain CDO equity fundamentals to

this wider universe of potential buyers.

Healthy Risk-Adjusted ReturnsWith an experienced CDO manager, the positive spread differential betweenthe yield on the pool of high yield bonds and the lower borrowing costs of theCDO can produce healthy risk-adjusted returns to income note holders in therange of 15%–20%.

Weak Correlation With Other Asset ClassesCash flow CDO equity returns are driven by the performance of a pool of highyield bonds and bank loans, asset classes that have not shown a strongcorrelation with other asset classes such as stocks and investment-grade bonds.

Key Drivers of ValueKey quantitative factors in CDO equity returns include the level and timing ofdefaults and recoveries and the movement of interest rates. In the ReturnAnalysis section of this report, we analyze how these factors can affect CDOequity returns. In addition, we will explore how three important qualitativefactors determine relative value among income note opportunities: collateralmanager, asset characteristics, and structure.


6

Role of the Collateral ManagerThe experienced CDO manager can outperform the market and generateoutsized equity returns. Managers with strong research teams, broad industrycontacts, a deep understanding of the intricate CDO investment rules, robustdeal flow, and sophisticated credit monitoring systems have a good chance ofoutperforming the market. CDOs managed by “two guys and a Bloomberg” areat a distinct disadvantage.

Investment StrategiesSince CDO equity returns rely heavily on the experience of the CDO managerand the time during which the CDO assets were purchased, investors shouldconsider two alternative investment strategies. One is to review the forwardCDO calendar and select income notes from various CDO issuers, therebymaximizing diversification among different credits and investment styles. Theother is to pre-qualify certain “blue-chip” CDO managers and invest in each oftheir CDOs over time.


7

CDOsCollateralized debt obligations (CDOs) are formed when asset-backed structuringtechnology is applied to a pool of corporate credit exposures. Total rated issuance ofCDOs has boomed in recent years (see Figure 1).

Figure 1. Moody’s Rated Volume, 1988–1999

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1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 19990

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Rated Volume (left scale)

Number of Deals (right scale)

Mill

ions

Source: Moody’s Investors Service.

CDO structures can be segmented into three categories:

É Cash flow,

É Market value, and

É Credit derivative.

Cash flow CDOs, which currently are the most prevalent CDO structures, rely upon thecash flow generated from the pool of assets to service the issued debt. This report willfocus on cash flow CDO income notes.

A CDO is created when a special purpose vehicle (SPV) is established to acquire apool of high yield corporate bonds, bank loans, or other debt obligations (see Figure2). In order to fund the acquisition of the debt obligations, the SPV issues rated andunrated liabilities. Since the majority of the these liabilities are highly rated, theCDO can raise most of its capital cheaply in the investment-grade market and investit more profitably in other markets including the high yield market.

Introduction

Since 1996, CDOissuance has boomed.

This report will focus oncash flow CDO income

notes.

CDOs raise capitalcheaply in the

investment-grade marketand invest it more

profitably in the highyield market.


8

Figure 2. Typical CDO Structure

COLLATERALMANAGER

TRUSTEE

ISSUER(SPV)

HEDGECOUNTER-

PARTY

CREDITENHANCER

SELLER

HIGH YIELDBOND

PORTFOLIO

INVESTORS

SUBORDINATEDNOTES

INCOME NOTES

SENIOR NOTES

BOND INTERESTAND PRINCIPAL

CDO NOTES

BOND PORTFOLIO

BONDPORTFOLIO

CDONOTE

PROCEEDS

CDO NOTE PROCEEDS

CDO NOTE PROCEEDS

Seller: Sells the bond portfolio to the issuer.Issuer: Issues CDO notes and uses note proceeds to buy bond portfolio.Investors: Purchase CDO Notes.Collateral Manager: Manages bond portfolio.Trustee: Fiduciary duty to protect investors’ security interest in bond portfolio.Hedge Counterparty: Provides interest swap to hedge fixed/floating rate mismatch.Credit Enhancer: Guarantees payment of principal and interest to note holders. Optional.

Source: Salomon Smith Barney.

In a typical cash flow CDO, the rated liabilities are tranched into multiple classes,with the most senior class receiving a triple-A or double-A rating and the mostsubordinated class above the income note receiving a double-B or single-B. Theratings on the classes are a function of subordination and how cash flow and defaultsare allocated among them. Principal and interest cash flow are paid sequentiallyfrom the highest-rated class to the lowest, but if the cash flow is insufficient to meetsenior costs or certain asset maintenance tests are not met, most or all cash flow ispaid to the most senior class.

Cash Flow CDO Income NotesCDO income notes are typically unrated and represent the most subordinated part ofthe CDO capital structure.1 These notes will receive the residual interest cash flowremaining after payment of fees, rated note holder coupon and the satisfaction of anyasset maintenance tests. Factors that will impact the residual interest cash flowinclude the level and timing of defaults, the level and timing of recoveries and themovement of interest rates. Income notes returns are generated by capturing thespread differential between the yield on the pool of fixed income assets (the majorityof which are high yield bonds and bank loans) and the lower borrowing cost of theinvestment-grade and the noninvestment-grade debt issued by the SPV. This positive

1 Duff & Phelps Credit Rating Co. has recently developed criteria for rating CDO equity: DCR’s Criteria For Rating “Equity” of

Cash Flow CDOs, January 2000.

The ratings on CDOclasses are a functionof subordination and

how cash flow anddefaults are allocatedamong these classes.

CDO income notes aretypically unrated and

they represent the mostsubordinated part of the

CDO capital structure.

CDO income notes cangenerate risk-adjustedreturns in the range of

15%–20%.


9

spread relationship can produce risk-adjusted returns to income note holders in therange of 15%–20%.

Once a cash flow CDO is issued, the collateral manager will manage the portfolioaccording to the investment guidelines set forth in the bond indenture and withinparameters necessary to satisfy the rating agencies. Pursuant to these guidelines, themanager will sell and buy assets and, during the reinvestment period, will reinvestcollateral principal cash flows into new bonds. The investment guidelines typicallyrequire that the CDO manager maintain a minimum average rating and portfoliodiversity such that any trading will have a minimal impact on the senior CDObondholders.

The primary responsibility of the cash flow CDO collateral manager is to managethe portfolio in a way that minimizes losses to note holders resulting from defaultsand discounted sales. To this end, all note holders rely on the manager’s ability toidentify and retain creditworthy investments. A manager’s trading decisions canhave a substantial impact on the returns paid to income note holders; the initial assetselection and its trading activity throughout the reinvestment period are critical toachieving high returns. A manager with a deep understanding of the underlyingcredit fundamentals of each of its investments can make informed, credit-basedtrading decisions, not trading decisions based on price movements.

Cash flow CDO income notes have many favorable characteristics. Among them are:

É Healthy returns. The risk-adjusted internal rate of return (IRR) to income noteholders can range from 15%–20%. This return rate compares favorably with thatof other investment opportunities (see Figure 3). We will explore the volatilityof this return in the “Return Analysis” section of this report.

Figure 3. Historical Returns — Various Asset Classes, 1990–2000

Index10 Year

Average (%)StandardDeviation

SharpeRatio

5 YearAverage (%)

StandardDeviation

SharpeRatio

Fixed Incomea

SSB Brady Bond Index 17.52 15.98 0.78 17.52 17.88 0.69SSB HY Market Index 10.94 6.39 0.92 9.71 5.25 0.86Corporate Bond Index 8.27 4.58 0.70 8.15 4.66 0.63Intermediate Term Treasury Index 7.89 5.79 0.49 7.95 5.78 0.47Mortgage Bond Index 7.84 3.17 0.88 7.93 2.87 0.95SSB Broad Investment-Grade (BIG) Index 7.75 3.88 0.69 7.74 3.74 0.68AAA Rated Corporate Bond Index 7.65 3.70 0.70 7.46 3.68 0.61

Equities

Nasdaq Composite 24.50 20.62 0.94 40.17 22.82 1.53S&P 500 18.27 13.42 0.98 28.72 14.07 1.67DJIA 16.17 14.26 0.78 24.56 15.65 1.24aFor more information on Salomon Smith Barney indexes, please see April 2000 Performance, Total Rate-of-Return Indexes, Salomon SmithBarney, May 2, 2000.Source: Salomon Smith Barney.

Trading decisions canhave a substantial

impact on the returns toincome note holders. A

good cash flow CDOmanager bases trading

decisions on creditfundamentals rather than

price movements.


10

É Lack of correlation with other asset classes. Although there is no establishedindex for CDO income note returns, the performance of the traditional cash flowCDO income note is directly linked to the behavior of a pool of US high yieldbonds. US high yield bonds have not shown a strong correlation to other assetclasses (see Figure 4).

Figure 4. Correlation of Various Asset Classes, 1990–2000

SSB HYMkt Index

3 MonthTreas. Bill

Brady BondIndex Corporate

Treasury7-10 Year BIG

AAA RatedCorporates

MortgageIndex

NasdaqComposite DJIA

3-Month Treasury Bill -0.08SSB Brady Bond Index 0.47 0.11Corporate Bond Index 0.53 0.10 0.34Intermediate Term Treasury Index 0.30 0.09 0.19 0.94SSB Broad Investment-Grade (BIG) Index 0.41 0.14 0.26 0.98 0.98AAA Rated Corporate Bond Index 0.45 0.11 0.28 0.98 0.97 0.99Mortgage Bond Index 0.43 0.22 0.29 0.90 0.87 0.94 0.91Nasdaq Composite 0.51 -0.05 0.43 0.29 0.16 0.21 0.25 0.21DJIA 0.53 0.00 0.59 0.38 0.25 0.32 0.33 0.35 0.71S&P 500 0.54 0.00 0.56 0.47 0.35 0.40 0.42 0.42 0.82 0.92


É Top-tier fund managers. An income note investment allows an investor to gainexposure to an experienced CDO manager and the healthy returns it cangenerate, with a smaller initial investment than might otherwise be required.

É Access to esoteric assets. An income note investment can be an efficient wayfor an investor to gain exposure to a variety of esoteric asset classes. Certainasset types, such as leveraged loans, mezzanine loans, and project finance loans,are asset classes to which relatively few investors have access.

É Cash flow-based returns. Returns on cash flow CDO income notes are drivenby the cash flow generated from the assets, not the market value or the price ofthose assets. This characteristic enables the investor to mitigate market risk andallows the manager to focus on the underlying credit fundamentals of the highyield collateral. The investment is especially attractive when there is adislocation in the high yield market due to technical, not credit, factors (e.g., infourth-quarter 1998). This stands in stark contrast to high yield mutual fundreturns, which are sensitive to market value fluctuations.

É Diversification. A relatively small investment in a cash flow CDO income notecan confer substantial diversification benefits. An investor can gain exposure to50–120 obligors across 15–25 industry sectors.

É Structural protections. Income note holders benefit from a variety of structuralfeatures present in cash flow CDOs. Chief among them is the ability to remove theportfolio manager and the right to call the deal after the end of the noncall period.

É Front-loaded cash flows. Unlike other alternative investments (e.g., privateequity) an investment in cash flow CDO income notes will typically generatecash flow within six months of the initial investment.


11

É Transparency. Income note investments are more transparent than manyalternative investments. Every month, the trustee reports, among other things,trading activity, obligor names and exposure amounts, industry concentrations,and compliance or noncompliance with liquidity and asset maintenance tests.

É Imbedded interest rate hedges. Many CDOs are floating-rate obligationsbacked by pools of fixed-rate bonds. In order to hedge the mismatch between thefixed-rate assets and the LIBOR-indexed liabilities, most CDOs purchase acombination of interest rate swaps and/or caps. Although these hedges arebought for the benefit of the rated note holders, they also benefit the incomenotes as the residual interest beneficiary.

É Taxation. Non-US investors are not subject to US withholding tax on dividendsand gains from sale, exchange or redemption they receive from their investment.Tax-exempt entities are not subject to Unrelated Business Income Tax.

Although CDO equity has many favorable characteristics, prospective note holdersshould consider the risks associated with ownership. Some risks include:

É Subordination of the income notes. The income notes are the most subordinatednotes in the CDO capital structure. They receive interest cash flow only after feesand rated coupon interest are paid, and asset and cash flow coverage tests aresatisfied. No payment of principal of the income notes is paid until all other notesare retired and, to the extent that any losses are suffered by note holders, suchlosses are borne first by the income note holders.

Since the income notes are subordinated, prospective investors should considerand assess for themselves, given the manager’s track record, the likely level andtiming of defaults, recoveries and interest rate movements. The followingsection, “Return Analysis” provides numerous examples that will help investorsunderstand how these variables impact income note returns.

É Limited Liquidity and Restrictions on Transfer. Currently, potential incomenote buyers should not rely on a secondary market for CDO income notes. Theinvestment trades on a “best efforts” basis and in a typical transaction, the incomenotes will be owned by a relatively small number of investors. Also, beforeselling an income note in the secondary market, the seller must comply withvarious regulations that restrict the transferability of certain types of securities.

É Mandatory Principal Repayment of Senior Notes. If the aggregate assetbalance is insufficient to meet the minimum overcollateralization test or theaggregate asset yield is insufficient to meet the minimum interest coverage test,cash flow that would have been distributed to the income notes will be divertedto amortize the most senior notes. If this occurs, the capital structure will de-lever until the test(s) are brought back into compliance. A de-levering structurewill have a negative impact on income note returns.

É Reinvestment Risk. During the reinvestment period the collateral manager willreinvest principal collections in additional bonds and loans. Depending onmarket conditions and the CDO’s investment guidelines, the manager may


12

purchase loans and bonds with a lower yield than the initial collateral (i.e.,spread compression), resulting in less cash flow for all note holders.

One way to mitigate some of these risks is to bundle the income note with a zerocoupon Treasury STRIP (or other security free of credit risk) and create a principal-protected structured note or unit (PPU) (see Figure 5). These units are designed toprotect income note holders from the loss of their initial investment while stillproviding the potential of some yield upside. Moody’s can rate PPUs Aaa, therebyallowing insurance company investors to gain NAIC1 capital treatment.

Figure 5. Principal Protected Units

$10,000,000Income Notes

Price

Trust

$8,2000,00012-year Treasury Zero Price

Price (Treasury Zero) + Price (Income Notes) = Par (Treasury Zero)

$10,000,000 ofIncome Notespriced at par

$18,2000,000 par of 12-year Treasury Zero, with

a price = $8,200,000

$18,200,000PPU

“Aaa”


Some risks associatedwith owning CDO income

notes can be mitigatedby bundling it with a

Treasury STRIP.


13

The vast majority of CDOs are privately placed. As a result, publicly available dataon the historical performance of CDO bonds is scarce. This dearth of informationmakes it difficult to use traditional statistical techniques to analyze CDO incomenote returns and the volatility of those returns. The lack of historical information,however, does not mean that returns cannot be analyzed under a variety of stressscenarios.

An internal rate of return (IRR) of 15%–20% is often bandied about in themarketplace, but how robust and predictable is this return? What assumptionsunderlie such forecasted returns? The answers to these questions depend on theconfluence of a number of factors, including:

É Magnitude and timing of defaults and sales at a discount to par.

É Magnitude and timing of recoveries.

É Interest rate movements.

É Calls and tenders.

DefaultsSince most CDOs are repackagings of high yield corporate bonds and loans, theirperformance is correlated with the default trends in the high yield market. Accordingto Peters and Altman,2 that default trend has been rising during the last few years, withaggregate defaults reaching 4.15% in 1999, up from 1.6% in 1998 (see Figure 6).Peters and Altman cite a number of factors contributing to the rising default rate,including heavy high yield bond issuance from 1997 to 1999, a trend toward defaultsoccurring a shorter period of time after issuance, deteriorating credit quality of newissues, and significant defaults in certain industries. Over the life of the study,however, defaults have been approximately 3% per year.

It is also important to note that although the performance of the CDO sector iscorrelated with high yield corporate sector in general, they are far from perfectlycorrelated. A CDO, after all, does not own all the credits in the high yield universe.It owns a carefully selected, diverse portion. Top-tier portfolio managers haveproven that they can consistently experience lower defaults than the marketplace asa whole. As will be discussed in the “Asset Manager” section of this report, assetselection and the manager’s long-term track record are key.

2 Gregory J. Peters and Edward I. Altman, Defaults and Returns on High Yield Corporate Bonds, Analysis through 1999 and Default

Outlook for 2000–2002, January 31, 2000.

Return Analysis

The lack of publiclyavailable CDO

performance data makesits difficult to use

traditional statisticaltechniques to analyze

CDO income notereturns.

In the high yield market,defaults have averagedaround 3% since 1971.

Top-tier portfoliomanagers have proven

that they canconsistently experiencelower defaults than the

marketplace as a whole.


14

Figure 6. Historical Default Rate, High Yield Bond Market, 1971–1999

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4

6

8

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1219

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1999

Defa

ult R

ate

(%

)


While the average annual default rate for the entire high yield universe has beenabout 3% over the last thirty years, the relatively small number of obligors in thetypical CDO (i.e., 70–120) will result in default behavior that is considerably morevolatile than any historical study. Consequently, we question whether the StreetCDO equity pricing convention of applying a level 2% annual default rate is valid. Itis impossible to predict which default pattern will prove to be the “right” pattern butit certainly will not be a smooth, steady 2% every year for the life of the incomenote. The prudent investor will take a view on future default behavior and test anincome note under varying default assumptions before investing.

Unless otherwise stated in a particular figure, the base assumptions listed in Figure 7will apply in all figures. Figures 8–9 illustrate the impact of various defaultscenarios on equity returns.

Figure 7. Cash Flow Modeling Assumptions

Base line default rate 2%Recovery rate 50%Liability weighted-average cost of funds 10yr UST + 2.25%Asset yielda 10yr UST + 5.20%Fees 0.55%Reinvestment Rate 11%Interest rate hedge Notional amount equal to 90% of the initial asset baseaNet of management fees.Source: Salomon Smith Barney.

When assessing thecharacteristics of a

particular income note,investors should not relysolely on the Street CDO

equity pricingconvention of applying a

smooth 2% annualdefault rate.


15

Figure 8 is representative of the current equity pricing paradigm of applying a“smooth” default number over the life of the cash flow scenario. If a CDO’s annualdefaults match the historical average of 3% described in the Peters and Altmanstudy, the equity IRR would equal 14.8%, the PPU (Principal Protected Unit) IRRwould equal 10.1% and an unleveraged investment in the pool would return 9.3%.As Figure 8 illustrates, the annual default rate must exceed 4% over the life of theCDO in order to make the unleveraged investment in the pool of bonds a bettervalue relative to the leveraged equity investment. Interestingly, if annual defaultsstay at a 3% rate, the PPU investment returns a paltry 0.8% above the collateral yield(10.1% versus 9.3%).

Figure 8. CDO Income Note Returns — Sensitivity to Annual Default Rates

7.9%

4.7%4.6%

8.9% 8.4%9.3%

10.7% 10.2% 9.8%

13.5%

8.2% 6.5%

10.1%

15.0%

11.8%9.8%

23.4%20.8%

17.9%

14.8%

-2.1%

-5%

0%

5%

10%

15%

20%

25%

0% 1% 2% 3% 4% 5% 6%

Annual Default Rate (Cumulative Default Rate)

IRR

Collateral PPU Equity

(0%) (7.5%) (14.8%) (21.4%) (27.2%) (33.2%) (36.9%)


Figure 9. CDO Income Note Returns — Sensitivity to Default Rate Spikes

-3.8%

0.9%4.1%

7.4%

11.1%

14.6%

3.5%

7.3%

10.5%

13.4%

-0.5%

16.3%17.9%15.5%

13.4%11.4%

9.0%

6.1%

16.5%

-5%

0%

5%

10%

15%

20%

2% 4% 6% 8% 10% 12% 14%

Spike

IRR

Year 1 & 2 Spike Year 3 & 4 Spike Year 5 & 6 Spike


If a CDO’s annual lossesmatch the 3% historic

average, the equity IRRcan equal a respectable14.8%. An experienced

CDO manager can doeven better.

The annual loss ratemust exceed 4% (27.23%

cumulative) to make anunleveraged investment

in the pool of bonds abetter value relative to

CDO equity.


16

Figure 9 illustrates the impact of default rate “spikes” on the equity IRR. Since smallpools of corporate debt obligations have no predictible loss curve, default rate“spike” scenarios are key to understanding potential returns. If default rates remainin the 4% range (i.e., 33% above the historical average) for the next two years andthen revert to 2% per annum, Figure 9 shows an IRR of about 15% (14.6%). If, overthe next two years, default rates rise 50% above today’s average default rate (4.0% *1.5 = 6.0%) and then revert to 2% per annum, the equity IRR in Figure 9 will equalapproximately 11.1%.

As Figure 9 illustrates, loss avoidance in the early years is key.

RecoveriesAs default rates rose in 1999, recovery rates dropped.3 The average recovery afterdefault was 28% in 1999, the lowest since 1990 and lower than both the 1998recovery rate (36%) and the average recovery rate from 1978 to 1999 (42%); seeFigure 10. This was the case even though less than 40% of the defaulted obligationswere subordinated. One reason for the drop in recovery rates in 1999 may be thecurrent glut of distressed and defaulted corporate paper.

Another contributing factor may be how some CDOs treat defaulted bonds. The waya CDO structure treats distressed and defaulted assets can have an impact on itsovercollateralization (OC) test as well as on the ultimate recovery that the managerreceives on the asset. Both of these can affect returns to the income note holders. Forexample, for the purpose of the OC test, defaulted assets typically are carried at thelesser of 30% or the market value of the asset. In addition, many structures requirethe manager to sell a defaulted assets at a maximum of one year after default.Distressed corporate market participants are all too aware of these artificialstructural constraints and, as a result, we have seen bids for defaulted paper at orslightly above 30 cents on the dollar. Since CDOs have become such huge buyers ofhigh yield paper and now hold, by our estimates, over 15% of the high yield market,their rules regarding the disposition of defaulted paper may have begun to affect thedistressed bond market.

3 Ibid.

Since small pools ofcorporate debt

obligations have nopredictable loss curve,

default rate “spike”scenarios are key to

understanding potentialreturns.

From 1978 to 1999, for allcorporate debt

obligations, the averagerecovery rate

immediately followingdefault was 42%.

CDO structural rulesgoverning the

disposition of defaultedassets are putting

downward pressureon recovery rates.


17

Figure 10. Annual Recovery Rates, 1971–1999

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Recove

ries

(%)


Lower sale prices drive recoveries lower and can ultimately diminish returns to theincome note holder. For this reason, when examining an income note opportunity, aninvestor should put historical recovery studies in the context of the last two years.The recovery paradigm may be shifting. Figures 11–12 illustrate the impact ofvarious recovery scenarios on equity returns.

Absolute recovery levels aside, all recovery studies show a tiering in recovery ratesbased on the defaulted instrument’s level of seniority and security.4 Historically,senior secured bank loans have shown the best recovery potential, followed indescending order by senior unsecured bank loans, senior secured bonds, seniorunsecured bonds, and subordinated bonds. An investor should determine thepotential asset mix of a CDO and the assets that are most likely to default beforetaking a view on the average recovery rate that the CDO may experience. Dependingon the mix, the average recovery rate of 42% cited above may be too conservative ortoo generous. Either way, given the relatively small number of assets in a CDO, theactual recovery experience may differ from the averages cited in industry studies.

4 Karen Van de Castle and David Keisman, “Recovering Your Money: Insights Into Losses from Defaults,” Standard & Poor’s

CreditWeek, June 15, 1999; and David T. Hamilton, Debt Recoveries for Corporate Bankruptcies, Moody’s Investors Service,Global Credit Research, June 1999.

The recovery paradigmmay be shifting.


18

Figure 11. CDO Income Note Returns — Sensitivity to Recovery Rates and Annual Default Rates

15.6%

9.0%

1.7%

-11.4%

19.8%

20.8%23.4%

4.6%

9.8%

14.8%17.9%

21.9%

14.6%16.4%18.4%20.2%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

0% 1% 2% 3% 4% 5%

Annual Default Rate

IRR

30% Recoveries 50% Recoveries 70% Recoveries


Figure 12. CDO Income Note Returns — Sensitivity to Recovery Rates and Default Rate Spikes

15.6%

-0.7%

5.0%

10.1%

17.9%

14.6%

11.1%

7.4%

15.0%

17.2%18.8%

20.2%

-5%

0%

5%

10%

15%

20%

25%

2% 4% 6% 8%

Spike — Years 1 & 2

IRR

30% Recoveries 50% Recoveries 70% Recoveries


Interest-Rate RiskMany CDOs are floating rate obligations backed by pools of fixed-rate bonds and, inorder to hedge potential interest rate mismatch, most CDOs purchase a combinationof interest rate swaps and caps. Hedging is one of the least standardized features of acash flow CDO and, as a result, it must be analyzed on a deal-by-deal basis.

Most CDOs are not perfectly hedged because such a hedge would be prohibitivelyexpensive. Incremental hedging costs are funded by the issuance of additionalincome notes, thereby diluting equity returns. Historically, as a result, most equity

Most CDOs are notperfectly hedged.


19

investors have been willing to accept some interest rate risk in exchange for returnsthat have not been dampened by excessive hedging costs.

In a typical CDO, the trust pays a fixed rate of interest to the counterparty and thecounterparty pays LIBOR to the trust. The swap notional amount amortizes pursuantto a schedule set at closing. Figure 13 assumes that the notional amount of a hedge isequal to 90% of the CDO capital structure and that the CDO liabilities are floatingrate notes indexed to LIBOR.

Figure 13. CDO Income Note Returns — Sensitivity to LIBOR Movements

4.7%

22.7%

17.1%

13.9%

9.7%

0.3%

20.1%

-2.1%

4.6%

20.8%

9.8%

14.8%

17.9%

23.4%

-5.1%

4.2%

9.9%

15.6%

18.7%

21.6%24.1%

-6%

-2%

2%

6%

10%

14%

18%

22%

26%

0% 1% 2% 3% 4% 5% 6%Annual Default Rate

IRR

LIBOR +200bp Forward LIBOR Curve LIBOR -200bp


Call and Tender PremiumsWhen a high yield bond is called or tendered, the premium paid to bondholdersoften equals half the annual coupon. Since many CDOs treat this premium as part ofasset yield collections, increased call and tender activity can mean increased returnsto the CDO income notes. We estimate that call and tender activity in the high yieldmarket, while volatile, has averaged about 8.5% in the last seven years (Figure 14).Figure 15 demonstrates the effect of assuming a 2.5% and 5.0% annual call/tenderrate. The figure assumes the calls/tenders are at a price of 105. At a 3% annual lossrate, a 2.5% call/tender rate can boost the equity IRR by more than 100bp.

Figure 14. Historical Calls and Redemptions (Dollars in Millions)

1993 1994 1995 1996 1997 1998 1999 Average

Calls/Redemptions 28,828 17,386 10,664 7,281 16,504 19,195 9,514Tender Offers 1,982 2,383 3,660 10,507 20,290 24,716 18,178Avge Size of HYM 213,537 237,297 261,453 301,453 363,917 453,047 534,361

Calls/Redemptions/Tenders as a % of HYM 14.43% 8.33% 5.48% 5.90% 10.11% 9.69% 5.18% 8.45%


LIBOR shifts can impactequity returns depending

upon how the liabilitiesamortize in relation to

the notional amountof the swap.

Although call andtender premiums can

boost returns by morethan 100bp in some

scenarios . . .


20

Figure 15. Sensitivity to Call and Tender Premiums

11.35%

4.63%

9.77%

14.76%

17.92%20.85%

23.41%

6.49%

16.10%

18.99%

21.81%24.28%

7.32%

12.68%

17.32%

19.99%22.71%

25.12%

0%

5%

10%

15%

20%

25%

30%

0 1 2 3 4 5Annual Defaults

IRR

No Premium 2.5% Annual Premium 5% Annual Premium


Although it may be tempting assume call premiums when analyzing CDO equity, werecommend against it for a few reasons. First, call and tender activity is driven by anumber of factors including changes in interest rates and company specific events.Over the 12-year legal life of the CDO, it is extremely difficult to predict themovement of interest rates and the effect of those interest rate changes on the highyield market as a whole, much less the impact on the 80–150 names that the CDOholds at any point in time. Also, many CDOs today contain a percentage of loans.Typically, loans may be prepaid without penalty at par at any time. Most importantly,while premiums offer some potential IRR upside, credit losses present a much largerthreat on the down side. It would take a large number of calls at 105 to outweigh theimpact of a few assets defaulting and being liquidated at 40, 20, or 10.

In addition to the numerous quantitative considerations explained above, there are anumber of key qualitative factors that will determine relative value among incomenote investment opportunities. These factors fall into three main categories:(1) collateral manager; (2) asset characteristics; and (3) structural features. Theremainder of this report will explore these qualitative factors in depth.

. . . potential income noteinvestors should not rely

heavily on them whendeciding whether to

make an investment.


21

Collateral Manager ReviewAn arbitrage CDO is a hybrid-structured finance/corporate instrument whoseperformance is linked not only to the credit quality of the collateral and the nature ofthe structure but also to the portfolio manager’s trading decisions. The collateralmanager’s initial asset selection and trading decisions throughout the reinvestmentperiod are crucial.

The key attributes of a manager that investors should examine in depth are:

É Track record.

É Experience managing within the CDO framework.

É Level of institutional support.

É Investment and trading philosophy.

É Expertise in each asset class that the manager is permitted to invest in.

É Importance of CDO product to overall organization.

É Manager’s access to assets.

An asset manager review is the best way for an income note investor to get a firmgrasp of a manager’s strengths, weaknesses, and historical performance. Some keydiscussion points and portfolio performance information requirements are listed inFigures 16 and 17.

Collateral Manager

The collateral manager’sinitial asset selectionand trading decisions

throughout thereinvestment period are

crucial drivers of CDOincome note returns.


22

Figure 16. Collateral Manager Review Check List

Company Overview

Financial strength of the companyExperience in corporate lending and managing portfolios of high yield bonds and bank loansHow does managing a CDO fulfill the company’s strategic objectives?Importance of CDO to overall organizationPrior history managing CDOsIs entire CDO managed by a couple of key decision makers (“key person” risk)?Number of high yield funds under managementPerformance results relative to peer group and index benchmarksCompensation arrangements for the collateral managersWill the company purchase part of the CDO income note?

Research

Research methodologyIndustries coveredNumber of analysts and credits per analystDepth of analyst contacts with industry participantsAbility to expand research to cover additional industries required in a diversified CDOSample research reports

Underwriting and Investment Strategy

Credit and approval policyInvestment styleFacility with and understanding of bond indentures and loan covenantsDecision making process for buy and sell decisionsPricing sources and policies regarding securities valuation

Credit Monitoring

Procedures to service the CDO and to ensure compliance with the CDO transaction documentsDoes the manager have in-house cash flow modeling capabilities or does it rely solely on the trustee and/or underwriter?Frequency of credit reviewsTechnological tools used to monitor the portfolioProcedures for managing credit-risk and defaulted assets

Sources: Standard & Poor’s, Fitch IBCA and Salomon Smith Barney.

Figure 17. Portfolio Performance

Defaults and Credit-Risk Sales

Default historyCredit risk sales below 80Asset specific rationale for each credit risk saleWhere has each credit-risk asset traded after sale? Did it ultimately default?Length of time between an asset purchase and its sale as a credit-risk asset

Recoveries

Recovery historyMethod of disposition: sale after default or buy-and-holdRecovery timing

Trading

Annual turnover rate for the portfolioFrequency of credit-improved salesCredit-improved sales: average premium to purchase price

Returns

Compare annual returns to peer group and index benchmarksVolatility of annual returns



23

Asset SelectionA CDO manager can outperform the market depending upon which names andindustries it chooses initially and the trading decisions it makes during thereinvestment period.

Investors should be aware, however, that the time period during which the collateralmanager purchases its collateral (“cohort” or “time stamp”) can have as much effecton the performance of a CDO as the skill of the manager. For example, as a generalmatter, CDOs which ramped-up during the spring of 1998 have not performed aswell as other CDOs. During early 1998 asset spreads were tight and managers had toventure down the credit curve and invest in marginal credits in order to generatesufficient returns to CDO equity investors. One way CDO equity investors canmitigate the potential risk associated with cohort to identify a list of approved,“blue-chip”, CDO managers and invest serially in CDOs issued by those managers.

Time stamp aside, we agree with the thesis that the high yield market is not as efficientas other markets and, as a result, there are opportunities for CDO managers who arewell versed in fundamental credit analysis and have access to timely information tooutperform their competitors.5 The high yield market does not price every assetaccurately. An experienced manager knows which assets are cheap relative to defaultprobability and which are priced properly. Those CDO managers with strong researchteams, good industry contacts, robust deal flow, and sophisticated systems have a goodchance of outperforming the market.

Prudent asset selection is crucial because the asset pool supporting a typicalarbitrage CDO is granular. Although the trend is towards larger pools and smallerobligor concentrations, the typical high yield arbitrage CDO may have as few as 70–120 names. With obligor concentrations ranging from 1% to 3%, a handful of poorinvestment choices may substantially reduce returns to income note holders.

CDO Investment GuidelinesA good total return high yield manager does not necessarily equate to a good CDOmanager. Two major differences exist. Total return arbitrage CDOs are typicallyleveraged 8–12 times, and this leverage greatly magnifies returns and losses to the CDOincome notes. Also, managing within a CDO’s arcane and cumbersome investmentguidelines (which have been crafted to garner investment-grade ratings on the seniornotes from the rating agencies) can be challenging.

In a typical CDO, a manager must satisfy more than twenty investment guidelinesbefore making a trade. No trade is easy. Figure 18 illustrates the guidelines whichmust be satisfied before a manager can make a purchase.

5 Fitch IBCA, Management of CBOs/CLOs, Robert J. Grossman, December 8, 1997

The time period or“cohort” during which

the manager purchasesthe collateral can haveas much effect on the

performance of the CDOas the skill of the

manager.

Prudent asset selectionis key because the

asset pool supporting atypical arbitrage CDO

may contain as few as70–120 names.

A good total return highyield manager does notnecessarily equate to a

good CDO manager.

CDO investmentguidelines are myriad

and cumbersome.


24

Figure 18. Typical CDO Investment Guidelines

Minimum average asset debt ratingMinimum percentage of assets rated B3 or betterMinimum percentage of assets in U.S.Maximum percentage of assets outside U.S., Canada and U.K.Maximum percentage of synthetic securitiesMinimum diversity scoreMaximum single issuer exposureMaximum percentage in any S&P industry groupMaximum percentage in any Moody’s industry groupMaximum percentage of zero coupon bondsMaximum percentage of loan participationsMaximum percentage of floating rate securitiesWeighted average life testClass A, B, and C minimum O/C testsClass A, B, and C minimum I/C testsMinimum weighted average recovery testMaximum percentage of securities maturing after a certain dateMinimum average asset margin testMinimum average asset coupon testMaximum annual discretionary trading bucket


Given the complexity of these investment guidelines, a manager who currentlymanages one or more CDOs will have a distinct advantage over a first-time CDOmanager, all other factors equal. Although a new CDO manager may have aconceptual understanding of each of these guidelines in isolation, until a manageroperates within them and understands the interrelationship among all guidelines,they are difficult to master.

If a CDO collateral manager has mastered the investment guidelines within a CDO,in what ways may this benefit the income note holders? One way involves industrydiversification. All rating agencies encourage industry diversification for the benefitof the rated note holders. A manager must seek the optimal amount of industrydiversification: diversification that maximizes the rating agency “credit” to ratednote holders, minimizes forays into unknown industries, and generates a fair risk-adjusted return to income note holders.

Another way that an experienced CDO manager can benefit income note holders isby taking a balanced view of a CDO’s asset eligibility parameters. Many modernCDOs allow a manager considerable flexibility to invest in various nontraditionalassets, such as emerging market debt and structured finance obligations. These assettypes may generate significantly more yield than comparably rated high yield bonds.They present an enticing way for a manager to “juice up” returns to income noteholders. But, as with the perils of industry diversification, a manager who is tooaggressive in searching for additional yield in nontraditional products may invest inasset types that it does not understand. Enhanced returns to the income note holdermay not provide adequate compensation for the additional risk. A prudent CDOmanager will resist this urge and instead stick to asset classes that it understands,even if that means forgoing some yield opportunities. In the long run, this shouldensure a more stable, risk-adjusted return to the income notes.

A manager who iscurrently managing one

or more CDOs will have adistinct advantage over afirst-time CDO manager.

An experienced CDOmanager will take a

balanced view towardindustry and obligor

diversification.


25

CDO Manager TypesCDO managers run the gamut from giant, highly rated banks and insurancecompanies to small, specialized, high yield portfolio managers. The size of the CDOmanager does not, on its own, determine whether a particular income note is a goodinvestment opportunity. For example, a CDO business that is a tiny part of a largeinsurance company or bank may not receive the same level of attention as a CDObusiness which is managed by a high yield boutique. In the latter case, the success ofthe CDO business is crucial to the success of the business as a whole. On the otherhand, if an insurance company sponsored CDO falters or a key portfolio mangerdeparts, the insurance company will have greater financial wherewithal to supportthe CDO business and hire a capable replacement.

An income note buyer should also understand how the portfolio manager makes itsinvestment decisions. An institution that centralizes its investment decisions with oneor two key people runs the risk that those key people might leave the institution forother opportunities. For this reason, income note investors should try to ascertainwhether the sponsoring institution espouses an investment philosophy and whether thisphilosophy is shared by a broad cross section of the CDO management team. Theseteam members should participate actively in all trading decisions.

Another key indication of support is whether an institution has issued multiple CDOs. Ifso, this indicates an institutional commitment to the CDO business. That commitment isfurther strengthened if the institution is an income note investor in each of its CDOs.

Investment and Trading PhilosophyA CDO manager’s investment philosophy and trading style will have a significantimpact on returns to the income notes. A key indication of this style is how themanager strikes a balance between the rated notes and the income notes. Althoughrated note holders and income note holders share many of the same concerns, theirinterests diverge in some important ways. Their viewpoints often differ as to theoptimal investment and trading philosophy for a CDO manager.

Rated note holders occupy the majority of the capital structure of the CDO, and theirprimary concern is the preservation of principal and a coupon entitlement that isattractive relative to other similarly rated fixed-income instruments. These noteholders are concerned with initial asset selection before closing and during the ramp-up period. Once a transaction is ramped up, triple-A note holders are averse to aCDO collateral manager that actively trades the portfolio because they rely uponasset cash flow, not trading gains, to service their debt. As long as assets do notdefault, they will produce the necessary cash flow to service the rated debt. Themarket value of the underlying asset pool may be of interest as a leading indicator ofcredit quality, but it is not of primary importance to rated note holders.

Income note holders do not think in terms of preservation of principal and a fixedcoupon payment. They think in terms of cashflow and a return on their initialinvestment. As we have explained, this return is driven by, among other things,defaults, recoveries, interest rates, premiums, and trading gains and losses. Likerated note holders, income note holders focus on a manager’s initial asset selection,because prudent asset selection can minimize losses and benefit all note holders.Unlike rated note holders, however, income note holders are concerned with the

The size of the CDOmanager does not, on itsown, determine whethera particular income note

is a good investmentopportunity.

A manager that takes acollaborative approach

to asset selection is lesssusceptible to key

person risk.

A manager that has issuedmultiple CDOs and

has purchased equity ineach has indicated an

institutional commitmentto the business.

How will a managerstrike a balance betweenthe interests of the ratednote holders and income

note holders?

Rated note holders relyon asset cash flow, not

trading gains, to servicetheir debt.


26

market value of the assets in the CDO and the manager’s trading decisions, if any,regarding assets that are trading at premiums and discounts.

There are three categories of trades that a manager can make: credit-risk, credit-improved, and discretionary. Rated note holders and income note holders often havediffering views as to the advisability of a particular trade. If a manager has a CDO orCDOs outstanding, a potential income note investor can analyze the manager’s pasttrades and infer whether the manager has worked to preserve principal for all noteholders or has concentrated on enhancing returns to the income note holders.

É Credit-risk sales. A credit-risk sale is a sale of an asset that has declined in creditquality and that the manager reasonably believes will default with the passage oftime. A credit-risk asset is sold at a discount to par and this sale, in isolation,results in the reduction of the asset base supporting the notes. This loss ofprincipal will move the actual overcollateralization (OC) closer to the minimumOC trigger. If the minimum OC trigger is tripped, collections will be used to paydown the senior notes.

Rated note holders will view credit-risk sales favorably only if: (1) the assetultimately defaults; and (2) the sale price is greater than ultimate recovery on thedefaulted asset. If an asset is sold as credit-risk and does not default before theCDO is retired, the CDO has taken a loss (i.e., sale at discount to par) that it couldhave avoided if the asset had been held to maturity.

Income note holders may have differing views concerning credit-risk sales. Somemay prefer managers to hold onto credit-risk assets because any discounted salewould push actual OC closer to the minimum OC trigger and increase the risk ofde-levering. Other income note investors may prefer early aggressive sales ofcredit-risk assets at slight discounts rather than waiting for an asset to trade at asteep discount.

É Credit-improved sales. Credit-improved sales can benefit both rated and incomenote holders. The issue hinges upon how the premium is treated in the structure.The premium generated from a credit-improved sale may be treated as interestcollections and used to enhance returns to the income note holder or it can be usedto grow OC through the purchase of additional assets. Clearly, the latter methodbenefits all note holders. When a manager sells an asset that has improved incredit quality, the rated note holders lose the benefit of upward credit migrationbut if the sale proceeds (including premium) are reinvested in additional assets,the manger may be able to maintain or increase OC.

É Discretionary sales. Depending on the structure, a CDO manager also has thediscretion to trade 10%–20% of the portfolio annually. Not surprisingly, rated noteholders have a bearish view of unfettered discretionary trading: they prefer managerswith strong credit fundamentals to execute a long term investment strategy. Anyproblem credits can be traded under the credit-risk trading rules. In contrast, incomenote holders favor discretionary trading provisions, because these allow the managerto continually search for assets with the best risk-adjusted returns.

In the final analysis, trading is a two-edged sword. Trading can expose cash flowCDO note holders to market value risk, but it also can be used to improve the creditprofile of the pool of assets and could ultimately be a very positive force inmitigating credit risk.

A manager’s tradingpatterns in existing

CDOs can give potentialinvestors importantclues as to how the

manager has balancedthe interests of rated

note holders and incomenote holders.


27

Collateral MixIn addition to high yield bonds and bank loans, arbitrage CDOs increasingly includenontraditional investments (see Figure 19).

Figure 19. Nontraditional Assets

Loan participationsEmerging markets sovereign debtEmerging markets corporate debtDistressed debtCredit derivativesStructured finance obligationsConvertible bondsMezzanine loans with warrantsProject finance loans and bonds


Most CDOs have certain limitations or “buckets” for these types of assets, but thelimitations are different for each CDO. Such assets are often included in arbitrageCDOs because their generous yields enhance arbitrage opportunities for thecollateral managers and, ultimately, the income notes. Although these nontraditionalassets offer enticing yield pickup, the income note holders must be certain that thecollateral manger has sufficient investment experience in the particular asset class. Ifnot, enhanced short-term income note returns may be outweighed by significantlong-term credit risk.

The inclusion of nontraditional assets also raises a credit question. The credit riskinherent in all cash flow CDOs is analyzed using various corporate default studies.Since these are studies of corporate instruments they are not directly applicable toassets like structured finance obligations and project finance loans. Some haveargued, however that applying corporate default studies to structured financeinstruments is overly conservative, given that there have been far fewer structuredfinance defaults than corporate defaults over the last ten years.

Some nontraditional investments can be categorized as “bivariate risk” assets. Theseinclude loan participations, emerging market corporate debt, and credit derivatives.With respect to each of these assets, the CDO is exposed to the nonperformance riskof more than one counterparty. For example, if a collateral manager invests in acredit derivative, the CDO will not receive payment if either the underlyingreferenced obligation or the credit derivative counterparty fails to perform. MostCDOs allow a manager to invest up to 20% of a CDO’s assets in bivariate riskassets, but many managers do not avail themselves of this opportunity. If thecollateral manager plans to utilize the 20% bivariate risk bucket or has used it in pasttransactions, the income note holders should determine whether they are beingcompensated for this additional risk.

Asset Characteristics

Nontraditional assetclasses offer enticing

yield opportunitiesas long as the manager

has investmentexperience in the

particular asset class.


28

Finally, the inclusion of nontraditional asset types may have an impact on assumedrecovery values. Over the last few years, several large recovery studies have beencompleted, but each revolves around defaulted US corporate bonds and loans. If amanager aggressively invests in sovereign debt or structured finance obligations, theapplicability of these studies becomes questionable.

Time Stamp or CohortThe period of time during which a CDO is ramped up can have a significant impacton its long-term performance. Depending on market conditions, the collateralmanager will purchase assets from both the primary and secondary market.Historically, a large percentage of the assets (10%–50%) emanates from the new-issue calendar, and during the average ramp-up period (3–6 months), that calendarcontains a finite number of names. Consequently, arbitrage CDOs that are rampedup during the same period may share a large percentage of the same names.Accordingly, if an investor purchases multiple income notes from CDOs that haveconcurrent ramp-up periods, there is the risk that the performance of these incomenotes may be correlated. This risk will decline after the end of the ramp-up period asthe manager starts trading the portfolio and the risk may not be as pronounced if oneCDO manager is purchasing loans and the other is purchasing high yield bonds.

The prices of high yield bonds and bank loans during the ramp-up period can alsohave a big impact on the performance of a CDO. As we mentioned earlier in thereport, during the fall of 1998, prices for high yield bonds dropped and spreadswidened considerably for technical reasons, although underlying credit fundamentalswere relatively stable. CDO managers that purchased collateral during that time framewere able to buy good credit quality collateral at discounted prices. Discounted pricesallowed managers to purchase much more collateral than they had projected withoutgoing down the credit spectrum. Many of these deals, consequently, have assetbuffers that are significantly above their minimum overcollateralization tests. Thesemanagers did not time the market: it was fortuitous that they came to the marketduring that period.

For these reasons, if an investor is going to build a portfolio of income noteinvestments, we recommend that it purchase income notes that are issued duringdifferent time periods or cohorts. Investors can execute this strategy in two ways.They can review the new-issuance calendar for the next quarter or two and selectincome notes from various CDO issuers. This would give them maximum exposureto different credits and CDO manager investment styles. Alternatively, since theperformance of CDO income notes is tied so closely to the skill of the manager, aninvestor may approve certain “blue-chip” managers and buy income notes from eachof their deals over time. An investor who chooses the second strategy will likely beexposed to some of the same credits across all CDOs that a manager issues. Amanager tends to buy additional exposure to names it likes.

Arbitrage CDOs that areramped up during thesame time period may

share a large number ofthe same names and,

consequently, theirperformance may

be correlated.

During the ramp-upperiod, the relative

richness or cheapness ofthe underlying high yieldmarket can have a long-

term effect on theperformance of a CDO.


29

DiversificationThe rating agency methodologies encourage obligor and industry diversity. Thetheory is simple: since CDO asset pools are lumpy to begin with, the more names inthe pool, the less any one obligor default can hurt note holders. Similarly withindustries, if one industry is experiencing higher than average defaults, note holders’exposure to that industry is limited. Rated note holders favor broad diversificationbecause they are interested in preservation of principal and the payment of a fixedcoupon. Income note holders are less sanguine about zealous diversification becausediversification, while limiting credit risk, also limits upside opportunities. Theincome note holder wants the manager to make a few right “picks” that can have adisproportionately beneficial impact on income note returns.

How does the manager strike a balance between the interests of the rated noteholders and the interests of income note holders? At some point, too much diversitycan work against all note holders. No note holder benefits if overly restrictive CDOinvestment guidelines force a manager to invest in obligors and industries that itdoes not fully understand. Credit risk increases and income note returns decline.


30

Unlike certain structured finance products (e.g., credit card ABS), CDO structuresare far from commoditized. Every CDO underwriter uses a different base structure,and even CDOs underwritten by the same banker can contain significant structuralvariations that can affect the income note holder. Income note investors who studythese features in each CDO before deciding to invest may be able to deduce how themanager intends to strike a balance between the interests of the rated note holdersand the interests of the income note holders.

The structure of a CDO is an important consideration for the income note holderbecause the income notes are structurally subordinated to the other notes issued bythe CDO. From a cash flow perspective, the income note holder is not entitled tocash flow until payment of: (1) all fees and expenses (capped and uncapped);(2) interest and principal to more senior notes; and (3) all hedging costs (includingtermination payments). If these obligations have been paid and the minimum interestcoverage (IC) and overcollateralization (OC) tests are in compliance, the incomenotes are eligible for distributions.

Trigger LevelsAll arbitrage CDOs contain two types of coverage tests: an asset coverage test(minimum OC test) and a liquidity coverage test (minimum IC test). If these tests areviolated, reinvestment of principal ceases and principal and interest collections areused to accelerate the redemption of the senior notes until these tests are broughtback into compliance. These triggers function as structural mitigants to credit risk.Because violation of these coverage tests can result in the payment of all cash flowto the senior note holders (and consequently none to the income note holders),income note holders should have a firm understanding of how they function.

One of the key ways to gauge the robustness of a projected IRR is to compare theactual OC and IC in the transaction to the minimum IC and IC triggers set by thecollateral manager and deal underwriter. If the difference between actual andminimum is small, the triggers have been structured “tightly” by the collateralmanager and the deal underwriter in an effort to give the CBO issuer a higher degreeof leverage (i.e., enhance the projected IRR to the income note). If the relationshipbetween actual and minimum is larger, the triggers have been structured more“loosely.” Although it may allow an underwriter to present a higher IRR to potentialincome note investors, a tight trigger is easier to violate and thus makes the IRRpotentially more volatile.

An income note investor should also explore the relationship between the actuallevels of OC and IC and the trigger points in the context of the overall credit qualityof the portfolio. A portfolio with an average credit quality of single-B should, allother factors equal, have a larger income note and less leverage (as a percentage ofthe deal) than a portfolio with an average credit quality of double-B. Also, the CDOsupported by the single-B portfolio should have a larger buffer between the actual

Structure

Although all CDOstructures share certain

structural elements, eachCDO structure is unique.

CDO income notes arestructurally subordinated

to the other notes in theCDO capital structure.

The IC and OC tests arestructural mitigants to

credit and liquidity risk.

Are the triggers“tight” or “loose”?

A tight trigger is easierto violate and thus

makes the IRRpotentially more volatile.


31

OC level and the minimum OC trigger, since single-B default rates are more volatilethan double-B default rates.

Finally, in most CDO structures, each class has its own minimum OC and IC testand the tests associated with the most subordinated rated class should trigger first.Nevertheless, the income note investor should analyze cash flow runs to understandunder a variety of stress scenarios which tests trigger the pay down of the deal.

Senior Costs, Swaps, and CapsPortfolio management fees and the coupon payable to the rated note holders are twocosts that can affect the cash flow payable to the income notes. An income noteholder should examine the manager’s fee in each CDO and compare it to feespayable in other arbitrage CDOs. A typical fee structure will pay the manager 0.25%prior to payment of interest on the rated notes and at least 0.25% after payment offees and rated note interest and the satisfaction of the IC and OC tests.

More importantly, as we have described in the Return Analysis section of this report,in many arbitrage CDOs the assets are primarily fixed-rated bonds and the liabilitiesare issued as LIBOR floaters. These deals typically use a combination of swaps orcaps to hedge interest rate risk. The swaps and caps usually have notional amountsthat amortize on a predetermined basis. This presents the risk that the transactionmay be underhedged or overhedged at any point in time (see Figure 13). If the dealis underhedged, for example, more of the asset cash flow will be used to meet ratednote debt coverage and less will be available for the income notes. Moreover, thesehedges can terminate, and if the SPV owes a termination payment to thecounterparty the payment will be made senior to payment of any residual cash flowto the income notes. Since termination payments can be large, investors shouldanalyze the swap documents for each deal and understand which events can causethe termination of the swap.

Manager Fees and Equity OwnershipThere are a few ways that a structure can more closely align a portfolio manager’seconomic interests with those of the income note holders. One way is through thepayment of the portfolio manager’s fee. In some older transactions, the manager’sfee is paid before payment of rated note holder interest. This senior position isbeneficial if the CDO needs to attract a replacement manager but it does not alignthe interests of the manager and the income notes. Even if the CDO is performingvery poorly, the manager still gets paid its full fee. For this reason, most recent dealspay part of the fee at the top of the waterfall (base management fee) and part of thefee after payments of other fees, rated note holder interest and the satisfaction of theIC and OC tests (performance management fee). By subordinating a portion of themanager’s fee, these structures encourage the manager to generate enough cash flowto service the rated debt in a fashion that preserves the asset base and does notviolate the IC and OC tests. Some structures pay the manager an additional fee if theactual IRR paid to the income note holder hits a certain target.

At any point in time, aCDO will be either

overhedged orunderhedged.

Swap terminationpayments are senior to

income notedistributions.

A split-fee structure andequity ownership more

closely aligns theeconomic interest of the

manager with theeconomic interests of

note holders.


32

Another way a manager can align its economic interests with those of the incomenote holders is by purchasing a portion of the income note. This is the case in mostCDOs. The theory: since the manager owns part of the income notes, it will managethe portfolio so as to produce reasonable returns to the income notes whileprotecting them from unreasonable credit risk. Although many deals do notexplicitly prohibit the manager from selling its portion of the income notes, as apractical matter the market for income notes is limited. In all likelihood, if amanager purchases income notes, it will retain them.

Credit-Improved Sales — Treatment of PremiumCDO investment rules allow a portfolio manager to sell an asset that has improved incredit quality and is now trading at a premium (credit-improved sale). What is acredit-improved sale and how are sale proceeds distributed? Definitions vary. Somestructures define a credit-improved sale as a sale of an asset that has improved incredit quality and can be sold at a premium to purchase price. Other CDO structuresdescribe a credit-improved sale as a sale of an asset that has improved in credit qualityand can be sold at a premium to par.

CDO structures treat gains differently. Some treat premiums as principal proceedsthat will be reinvested in new collateral. Rated note holders favor this treatmentbecause premium sale proceeds are used to buy more collateral and enhanceovercollateralization in the structure. Some income note holders may favor thistreatment for the same reason. Other structures treat premium sale proceeds asinterest proceeds that can be distributed to the income note holders if fees and ratedcoupon have been paid and the IC and OC tests have been satisfied. Rated noteholders do not favor this version, because it allows a manager to skim all the creditupside off the pool of assets and stream it to the income note holder in the form ofan enhanced IRR. Still other structures give the manager the option of designatingpremium proceeds as either interest or principal. Finally, another variation weighsthe cumulative losses against the cumulative gains that a manager has incurred overthe life of the CDO. If cumulative losses exceed cumulative gains, the proceeds ofany credit-improved sale are deemed principal proceeds.

Some structures reinvestpremium proceeds inadditional assets and

some characterizepremium proceedsas additional yield

eligible for distribution toequity holders.


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During the last few years, demand for CDO equity has broadened substantially fromlarge institutional investors to other investors such as small pension funds and high-net-worth individuals. A CDO equity investment program that purchases incomenotes from a select group of experienced CDO managers across various periods oftime can be a effective way for an investor to diversify its portfolio and improve itsrisk-adjusted returns. We expect that continued growth in the CDO market will driveincreased demand for CDO equity investments in the United States and in overseasmarkets, including Europe, the Middle East, and Asia.

Conclusion

ADDITIONAL INFORMATION AVAILABLE UPON REQUEST

For securities recommended in this report, Salomon Smith Barney (SSB), including its parent, subsidiaries, and/or affiliates (the Firm), usually makes a market,may sell to or buy from customers as principal, and may from time to time perform investment banking or other services for or solicit investment banking orother business from any company mentioned in this report. Securities recommended, offered, or sold by SSB: (i) are not insured by the Federal DepositInsurance Corporation; (ii) are not deposits or other obligations of any insured depository institution (including Citibank); and (iii) are subject to investmentrisks, including the possible loss of the principal amount invested. The Firm, or any individuals preparing this report, may at any time have a position in anysecurities or options of any of the issuers in this report. An employee of the Firm may be a director of a company mentioned in this report.

Although information has been obtained from and is based upon sources SSB believes to be reliable, the Firm does not guarantee the accuracy of the informa-tion, and it may be incomplete or condensed. All opinions and estimates included in this report constitute SSB’s judgment as of the date of this report and aresubject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase orsale of any security. This report does not take into account the investment objectives, financial situation, or particular needs of any particular person. Investorsshould obtain individual financial advice based on their own particular circumstances before making an investment decision on the basis of the recommenda-tions in this report. Investors who have received this report from the Firm may be prohibited in certain states from purchasing securities mentioned in thisreport from the Firm. Please ask your Financial Consultant for additional details.

This publication has been approved for distribution in the United Kingdom by Salomon Brothers International Limited, which is regulated by the Securities andFutures Authority. The investments and services contained herein are not available to private customers in the UK. This report was prepared by SSB and, ifdistributed by Nikko Salomon Smith Barney Limited, is so distributed under license. This report is made available in Australia through Salomon Smith BarneyAustralia Securities Pty. Ltd. (ACN 003 114 832), a Licensed Securities Dealer, and in New Zealand through Salomon Smith Barney New Zealand Limited, amember firm of the New Zealand Stock Exchange.

The research opinions of the Firm may differ from those of The Robinson-Humphrey Company, LLC, a wholly owned brokerage subsidiary of Salomon SmithBarney Inc. Salomon Smith Barney is a service mark of Salomon Smith Barney Inc. © Salomon Smith Barney Inc., 2000. All rights reserved. Any unauthorizeduse, duplication, or disclosure is prohibited by law and will result in prosecution.© Salomon Smith Barney Inc., 2000. All rights reserved. Any unauthorizeduse, duplication or disclosure is prohibited by law and will result in prosecution.

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