Heavyweights join the CDO party


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Europe's high-yield debt market is on its knees. Investors have had two years of heavy losses and new issuance has ground to a halt. But bankers predict rapid growth in a related area: the issuance of high-yield CDOs (collateralized debt obligations).

The supply of CDOs in Europe is booming. But the market is dominated by investment-grade credit deals, with the majority in synthetic rather than cash form (see page 72). Only 5% of European CDOs relate to high-yield assets, compared with 80% in the US.

The high-yield sector has been the preserve of buy-out specialists and private-equity houses such as Intermediate Capital Group and Duke Street Capital, rather than traditional money managers.

But that could be about to change. Pimco, regarded by many as the world's smartest fixed-income investment house, began a month-long roadshow at the end of January to market its first European CDO. The e400 million ($345 million) fund - to be called Intercontinental - will invest in sub-investment grade loans and bonds. Deutsche Bank is arranging the placement, which will price in mid-March and close in mid-April.

Mark Hudoff, director of European credit research at Pimco, says the fund will invest primarily in loans, roughly two-thirds against one-third in bonds. Euro-denominated assets will make up 70% with the balance in dollar and sterling assets.

Pimco and Deutsche have already started assembling the assets - or collateral, as it is known in the CDO business. They estimate that the fund will be around 50% invested by the time the offering closes.

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Deutsche says it is attracting good interest from a wide range of institutions including insurance companies, pension funds, fund managers and banks.

"Pimco is the largest bond manager in the world and it has a phenomenal track record in the high-yield market," says Jim Finkel, a director in Deutsche's global CDO group. Pimco already runs 13 high-yield CDO funds in the US. In Europe, this is its debut.

"This is the asset class within structured finance where you most rely on the quality of the manager," says Frederic Drevon, director in structured finance at Moody's. "To some extent it is the manager who determines whether the deal is a success or not."

Standard&Poor's started rating CDO managers in the US last September. It has issued two ratings: for Pimco and David L Babson. It has 10 more on the go and expects 50 by the year-end.

Europe's high-yield CDO market is unlikely to grow as rapidly as that in the US. The small size of the high-yield bond and loan markets in Europe is a drawback, making it difficult for managers to source collateral from comparatively illiquid markets.

In addition, the poor performance of the European high-yield bond market and the slower than expected pace of new issuance has damaged its standing in investors' eyes.

But participants predict that for two reasons the high-yield sector could become one of the fastest-growing areas of CDOs.

A high-yield CDO provides investors with relatively safe access to leveraged finance. CDOs are sold as a variety of securities, with investors able to take the tranches that suit their risk appetites, from the equity piece, which could yield 20% annually, to triple-A rated debt offering 50bp over government bonds.

They also offer a new source of institutional capacity for the leveraged finance markets - at a time when bank appetite for keeping high-yield, high-risk assets on the books is likely to be reduced by Basle 2.

The largest high-yield CDO fund in Europe is the e750 million Duchess fund launched last year by Duke Street Capital Debt Management, a venture set up by European private-equity house Duke Street Capital.

Ian Hazelton, chief executive of DSCDM and former managing director at Royal Bank of Scotland, believes CDO funds will become a core component of LBO funding, as bank capacity for buy-outs is being stretched.

"The institutional presence in the European credit markets is growing strongly," says Hazelton. "The impact of Basle will be that banks sell off leveraged loans and capital-intensive assets, but it is slower in being adopted by banks than we expected."

Although the LBO market has been virtually dead, Hazelton detects a revival. "The outlook for LBOs is not dramatic in terms of deal volume yet but we have been talking to arranging banks and they say the level of enquiry has gone through the roof," he says. The Duchess fund is over 80% invested, mainly through buying loans, and DSDCM is now planning a second fund. In theory, the fund can invest up to 25% in high-yield bonds, but the poor state of the market has meant that investment has been much lower.

"We have been very slow in building up our bond book because the market has been so volatile and new issuance has been slow," says Hazelton. "We are happier buying in the new-issue market rather than stuff like telecom paper in the secondary market, because it is so unpredictable."

Likewise, DSCDM prefers to be involved in leveraged loans at the arrangement stage - "because that is when the due diligence is done and we can have greater input," says Hazelton, but it will also buy in the secondary market.

"We are positioning ourselves as specialists in the LBO world," says Hazelton. "You need to know what you are doing in this game, otherwise you are likely to get sold a pup."