CDO guide: recovery rates
(Credit Magazine) For investors to feel comfortable with investing in CDOs they must feel confident about the circumstances under which they will win and lose. Here the recovery rate of the underlying assets is the key to performance
For investors in the CDO market, it is important to distinguish between default and recovery rates. A default is defined as occurring at the moment that a promised payment on a bond is missed by the issuer, or the time at which an announcement of a missed payment is made regardless of the allowable grace period. For example, the way that Moody’s rates bonds means: “If issuer ABC misses an interest payment on the due date but makes the payment during the grace period, Moody’s treats ABC as a defaulted issuer at the time of the missed payment.”
For CDO investors, therefore, the severity of loss rather than the severity of default is the key. Clearly, recovery rates in the event of liquidation of assets will vary widely across various claims in the capital structure. S&P’s recovery assumptions, for example, range from highs of 50% to 60% in the case of senior secured bank loans through to lows of 15% to 28% for subordinated debt and just 15% for emerging market corporates. For individual distressed credits, therefore, recovery rates can also vary dramatically. For example, according to figures published by S&P, recovery rates have varied from as low as 9–12% for WorldCom and 11–24% for Enron through to as high as 78–90% in the case of Railtrack in the UK.
Aside from the specific circumstances of default, a number of other factors can and do influence recovery rates. For example, on average, the longer collateral managers hold on to defaulted securities, the greater their recovery values become. That does not necessarily mean that collateral managers will usually aim to retain ownership of defaulted securities, because in most cases the terms of their contracts will make them forced sellers in a default scenario.
The important differences between default and recovery rates mean that calculating historical recovery levels and therefore extrapolating likely future trends is far from straightforward. A complication in the European market is that information on recovery rates has historically been kept private by banks in the loan market, forcing rating agencies and other analysts to apply a so-called ‘haircut’ to recovery rate data from the US, where much broader information on recovery rates for bonds and loans is available.
An added complication, especially for CDO investors tutored in the bankruptcy laws that apply in the US, is that insolvency regimes continue to differ throughout Europe. France, for example, is notorious for being highly protective of borrowers while Germany is regarded as being much more pro-secured creditors. Furthermore, as the Credit Guide to CDOs published in 2002 observed: “In many European jurisdictions, bond investors have no control over any work-out process: this is in stark contrast to the situation in the US, where both loan and bond investors get a seat at the table. As a result of these structural features, European high-yield bonds are proving to have abysmal recovery rates.”
Those poor European recovery rates, however, are not confined to the high-yield market. According to Moody’s, while the default rate in the European corporate bond market plunged from 20.1% in 2002 to 6.9% in 2003, the average recovery rate was almost unchanged at 19.9% in 2003 compared with 20% the previous year. Recovery rates in Europe, Moody’s advises, continue to be roughly half the North American average.
Structuring and constructing a CDO
The financial press will often make its first mention of a ‘new’ CDO on or around the time of its closing – with the closing date generally the day on which the CDO issues tranches of debt and equity to investors. Prior to that day, however, there will have been a so-called pre-closing or ‘warehousing’ period, typically lasting between three and six months. During that period the asset manager will have acquired (or ‘warehoused’) assets to act as collateral for the securities to be issued by the CDO via a special-purpose vehicle (SPV – see box) on the closing day. Closing of a fund usually occurs when a CDO has acquired between 40% and 60% of its targeted assets.
Clearly, however, given that the proceeds of the CDO notes will only become available following their sale on closing day, CDO managers will often need a bridging loan facility (or ‘warehouse facility’) during the warehousing period.
Following the issuance of notes on closing day, the CDO will have a period usually lasting between 60 and 360 days – although the period can also be much longer – in which to complete the process of buying the assets backing the CDO. This important phase is commonly known as the ramp-up period, and the year in which the ramping-up takes place is referred to as the CDO’s vintage. The final investment amount amassed following the ramp-up is sometimes known as the target par amount, which is the total size of the fund less its start-up costs. A portfolio that has been ramped-up with a relatively large number of small exposures is described as being granular, whereas a more concentrated portfolio with a small number of exposures is known as a lumpy fund.
After completion of the ramp-up, there is usually a reinvestment (or revolving) phase lasting up to five years, during which any cashflows arising from amortisation, maturity, prepayment or the sale of assets can be reinvested, as long as a number of basic performance objectives have been maintained.
Finally, during the amortisation phase, which can last for between five and 30 years depending on the underlying assets of the CDO, cashflows earned by the fund are used to pay down its liabilities.
| CDO repackaging (repacks) The repackaging of CDOs (known as CDO repacks) is a relatively recent phenomenon arising from the poor performance of a number of CDOs in 2002 and 2003, and another good example of the flexibility and adaptability of the market to respond to fluctuations in credit quality and economic volatility. Repacks are considered to be ‘first derivatives’ of CDOs and, as Moody’s explains: “In a typical repack, the terms of the existing CDO are restructured, with changes in seniority, notional amount, coupon, maturity and waterfall priority. The cashflows of the existing debt are used to support restructured debt securities to achieve the desired ratings.” Moody’s adds that repackaged structures, 45 of which were rated by the agency in 2003 compared with just 11 in 2002, will be able to achieve a higher rating due to an increased subordination and the support of extra interest. “After the restructuring of the existing CDO structure, the new bond will be more appealing to the investors who are seeking higher credit quality,” Moody’s notes. |
| The role of the SPV ABS (including CDOs) are generally issued by SPVs or special-purpose entities set up to allow for the transfer of risk from the originator to an entity that is generally thinly capitalised, bankruptcy-remote and isolated from any credit risk associated with the originator. According to a JP Morgan handbook: “To limit the universe of an SPV’s potential creditors, it is usually a newly established entity, with no operating history that could give rise to prior liabilities. The SPV’s business purpose and activities are limited to only those necessary to effect the particular transaction for which the SPV has been established (for example, issuing its securities and purchasing and holding its assets), thereby reducing the likelihood of the SPV incurring post-closing liabilities that are in addition or unrelated to those anticipated by rating agencies and investors.” |
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