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Deutsche Bank - The Arbitrage CDO Market (2000-03)

Deutsche Bank - The Arbitrage CDO Market (2000-03)

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Arbitrage CDO Issuance Activity (USD mn)
010,00020,00030,00040,00050,00060,000198819891990199119921993199419951996199719981999Mkt ValueCash Flow
Source: DB Global Markets Research
Table of Contents
Introduction:Lay of the land..............2Cash Flow CDOs:Managing Default Risk.4Market Value CDOs:Managing Price Risk...13Risk & Return:Relative ValueConsiderations............18Emerging Issuesand Alternative CDOSectors.......................21Appendix:Cash Flow vs. MarketValue CDOs................23Bibliography................24
Collateralized debt obligations have been around for over a decade, but ithas only been in the past three years that issuance volume has jumpedsignificantly, from about $20 billion to over $100 billion. Issuance hassoared due to investor demand and innovation.
There are two basic types of CDOs – balance sheet CDOs, which aredone by banks for regulatory capital purposes, and arbitrage CDOs, wherehigh yielding collateral is securitized and financed by relatively low costinvestment grade bonds.
A key sector of the market today is arbitrage CDOs backed by US-issuedhigh yield assets, otherwise known as CBOs. These transactions accountfor about 55% of total CDO volume but nearly 75% of deals.
Cash flow CDOs are structured so that investment grade bonds canwithstand the worst default experience seen over the past 30 yearswithout suffering losses. Market value CDOs are structured so thatinvestment grade bonds backed by below investment grade assets canwithstand multiples of the worst historic price volatility.
CDO bonds carry credit risk similar to comparably rated corporate bonds,but offer substantially wider spreads across the credit spectrum.
March 21, 2000
Nichol Bakalar
(212) 469 8362nichol.bakalar@db.com
Markus Herrmann
(49) 69 9103 8314(44) 171 547 2748markus.herrmann@db.com
John F. Tierney
(212) 469 6795john.tierney@db.com
David Folkerts-Landau
Managing Director, Head ofGlobal Markets Research
The Arbitrage CDO Market
Cash flow & market value CDOs lead the way
   G   l  o   b  a   l   M  a  r   k  e   t  s   R  e  s  e  a  r  c   h   R  e   l  a   t   i  v  e   V  a   l  u  e
The Arbitrage CDO MarketMarch 21, 2000
2Global Markets Research
Introduction: Lay of the land
Collateralized debt obligations (CDOs) are structured securities backed by diversifiedpools of bank loans, high yield corporate bonds, emerging market securities, or varioustypes of mortgage securities. The first collateralized bond obligation (CBO) was issued in1988, but this product really started to flourish in 1996 as investors sought yield in a lowrate and spread-compressed environment and issuers adapted the structuring technologyto new asset types (see Figure 1). In that year, issuance soared to about $20 billion afterbeing well under $5 billion for a number of years. Also supporting the boom in issuance in1996 was the strong risk-adjusted performance of the high yield market during the early1990s, which helped investors become more comfortable with the underlying collateral ofCDOs. Issuance climbed rapidly to over $90 billion in 1998, and reached $103 billion in1999.These products have been successful in recent years because they offer both higheryields than comparably rated investment alternatives, and diversification through accessto financial assets and money management expertise that would otherwise not beavailable to many investors. At the same time, sponsors and managers have beenenthusiastic proponents of CDOs because they provide an efficient means to increaseassets under management, and because the structuring technology can be adapted to awide variety of collateral and business purposes.
The CDO market can be distilled down to two basic products – arbitrage and balancesheet transactions. Arbitrage transactions seek to capture excess spread fromsecuritizing diversified pools of high yielding below investment grade loans or securities,and financing them largely through issuing relatively low cost investment grade debt.Arbitrage CDOs may be either cash flow or market value transactions. Cash flowtransactions are structured so that investment grade CDO bonds can withstand the worstdefault experience of the past 30 years without suffering losses. Market value CDOs arestructured so that investment grade CDO bonds can withstand multiples of the worsthistoric price volatility without suffering losses.Balance sheet transactions, on the other hand, are motivated by regulatory arbitrage.They have been done by banks seeking capital relief by moving high quality but lowyielding loan assets off balance sheet. These products are known as balance sheetcollateralized loan obligations (CLO).
Figure 1: CDO Issuance Activity ($ millions)
020,00040,00060,00080,000100,000120,000198819891990199119921993199419951996199719981999Cash FlowMkt Value - CBOMkt Value - MtgBal Sheet CLO
Source: DB Global Markets Research, rating agency reports 
CDO activity took off in1996 as investors sought yield and innovationflourished There are two basic types 
of CDOs – balance sheet and arbitrage transactions 
March 21, 2000The Arbitrage CDO Market
Global Markets Research3In terms of issuance activity arbitrage CBOs/CLOs have accounted for 65% - 75% of deal
activity and about 50 – 60% of dollar volume in recent years, with balance sheet CLOsmaking up the remainder. Within the arbitrage sector, cash flow transactions dominate,with a market share near 75%. US high yield securities are the primary collateral inarbitrage transactions. In 1997 and 1998 before the Russian default, emerging marketscollateral was used in some 25 transactions totaling $7.1 billion. Since then there havebeen only a few emerging markets CDO transactions as investors continue to beconcerned about potentially high default rates and extreme market value volatility.This report focuses on arbitrage CDOs, particularly those backed by US high yield debt. Inthe next section, we describe the basics of how cash flow CDOs are structured, andreview how the rating agencies analyze these transactions. We then do the same formarket value CDOs. While there are many similarities between cash flow and marketvalue CDOs, differences in how they are structured, managed, and rated warrant aseparate discussion for each one. We then discuss these products from a relative valueperspective, with emphasis on issues that investors new to this sector should consider.Finally we conclude with a brief discussion of emerging issues and products that CDOinvestors may see in the coming year. The appendix provides a summary and comparisonof key characteristics of arbitrage cash flow and market value CDOs.
This report focuses onarbitrage CDOs,particularly those backed by US high yield debt 

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