| Investors point out differences between hard-hit European and US structured products |
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| 27/01/2008 | |
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In a recent report to clients, JP Morgan's Global Structured Finance Research team notes that the CDO market has seen little issuance in recent weeks. Secondary activity, however, has picked up recently as bid lists are beginning to clear. Even as CLO spreads in the AAA sector have widened to 95bps from 23bps "we are looking to opportunistically add risk on price declines." CDO and CLO spreads have widened as banks and insurance companies, the traditional buyers of the asset class, have disappeared from the market. Active participants in the sector such as the monolines, which write protection on AAA tranches of CLOs, have been hard hit by their sub-prime exposure. "You take the funded/wrapper trade out of the equation and there are far fewer buyers of AAA CLO tranches," says one analyst. Bullet structure Yet there are also signs that investors are starting to differentiate the structures of AAA CLOs in Europe and the US even as the current sell-off has bundled the two markets together. While the widening of spreads is largely a reflection of an absence of liquidity, there is little evidence of stress at the collateral level of outstanding CLOs issued in Europe. That is largely a reflection of the lower liquidity needs of European companies compared to their US counterparts as the loans underlying European CLOs have a bullet structure. These companies have the advantage of repaying a large segment of their loan at maturity rather than being saddled with more onerous payments during the life of the loan. In Q1 2003, about 30% of the collateral in European CLOs had a bullet structure, according to JP Morgan. By Q4 2007, 80% of the collateral had a bullet structure. In addition, in the last six months, the loan age of the collateral underlying European CLOs has increased, thereby reducing European companies' immediate borrowing needs. Another important difference is that in the US CLOs may carry tail risk as they are more likely to be backed by covenant lites. The robustness of covenant lites prompted S&P to issue a report in June 2007 titled "The Covenant-Lite Juggernaut Is Raising CLO Risks." In order to reflect the incremental risks posed by cov-lite loans in its CLO-ratings, S&P proposed that these loans have an incurrence test involving a point-in-time review of a specific operating performance measure relative to a pre-determined trigger level after the borrower took a certain action such as debt issuance, share repurchases, acquisitions, divestitures or a merger. European CLOs are less likely to have covenant lites, yet much of these differences are being lost in the current turmoil, says Dominique Linder, Co-Head of Collateralized Debt at PIMCO in Munich. "If origination conditions in the two markets are different, why are certain structured products being valued the same way? asks Linder. "It is fundamentally not justified. This is not a credit risk issue, it is a liquidity issue. I cannot tell you when risk premia will shrink, however, in the foreseeable future spreads will come in as liquidity returns." VB |
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Articles of the same Topic : Structured Products |
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