Hedge Funds Revive the Junk Bond CDO
Hedge funds are using financial engineering common before the financial crisis to borrow money and buy high-yield bonds
By Matt Wirz and Matt Wirz
The Wall Street Journal
Nov. 7, 2018 7:00 a.m. ET
Wall Street financiers are reviving a complex transaction seldom seen since the financial crisis: collateralized debt obligations.
Issuance of corporate debt CDOs has tripled this year to at least $3.8 billion, according to data from LCD, S&P Global Market Intelligence. While still a small market, the increase shows investors are embracing complexity in pursuit of returns by reviving a type of financial engineering largely dormant since the crisis.
Hedge funds like Fortress Investment Group LLC, Anchorage Capital Group LLC and Brigade Capital Management LP are issuing the CDOs to generate annual returns exceeding 20%, people familiar with the investments said.
These latest CDOs are part of a small but fast-growing corner of the securitization market, which helped fuel the market meltdown of 2007-09 with similar instruments backed by mortgages. Investment banks are competing to structure and sell the new CDOs to yield-hungry investors because they earn relatively high fees on the business, while profits from more conventional trading have been falling for years.
Created with Highcharts 6.0.4Lift OffSales of junk-bond collateralized debtobligations, or CDOs, are reviving.Source: LCD, S&P Global Market IntelligenceNote: Figures measure large transactions and maynot include all new CDOs.
Managers of the CDOs issue bonds and equity to outside investors and use the proceeds—as well as equity they themselves contribute—to buy a portfolio of corporate bonds and loans. The CDO collects interest and principal payments from the debt it buys, then uses the money to pay interest and principal on its own bonds; leftover cash goes to the equity holders.
Equity holders receive the benefit of returns amplified by the use of borrowed money, or leverage. They can also gain if prices of the instruments purchased by the CDO rise. But they are first in line to absorb losses when those prices fall or loans and bonds in the pool default.
The securities are cousins to popular collateralized loan obligations, which bundle together secured corporate loans and issue securities backed by payments on the debts. Unlike CLOs, the CDOs buy unsecured high-yield bonds as well as secured loans—a risky twist that comes with a higher return.
Bankers and investors who trade in the new instruments said they are safer than the CDOs that contributed to the financial crisis because they use less borrowed money and have more cushion to absorb losses. The new market is also too small to trigger a systemic financial crisis the way the mortgage-bond collapse did in 2008, they said.
Insurance companies are buying the bulk of the CDO bonds. One large buyer has been Global Atlantic Financial Group, an insurer that spun out of Goldman Sachs in 2013, investors said. A spokeswoman for Global Atlantic declined to comment.
The hedge funds that manage the new CDOs have been putting up most of the equity in their deals, treating them as vehicles to lever firm capital. These cash commitments can still be large. Fortress issued a $1 billion CDO in March, implying a $250 million equity commitment.
CDO managers can currently only borrow about $3 million of bonds for each $1 million of equity they contribute or raise. CLO managers can borrow at a ratio of 9 to 1 because they only purchase loans, which recover more than bonds in default.
Thus far, CDO investors have mostly bought deals from name-brand managers that specialize in U.S. and European junk debt. But smaller firms are trying to break into the market with deals that are being viewed as a litmus test of investor appetite, CDO investors and managers said.
Miami-based fund manager RVX Asset Management LLC is one of the new entrants hoping to ride the CDO surge. The firm is working with investment bank Jefferies Financial Group LLC to issue a $200 million to $300 million CDO to buy corporate bonds in developing countries from Latin America to Asia, people familiar with the deal said.
Some investors are leery. Eagle Point Credit Management, which manages $2.5 billion of CLO equity and debt investments, is currently not looking to invest in the new CDOs, said Daniel Ko, a portfolio manager at the firm.
“We prefer CLOs because the underlying loans are senior secured and you’re first in line in case of default,” he said.
In some cases, hedge funds are putting equity into CDOs managed by others. Billionaire Paul Singer’s firm, Elliott Management Corp., purchased much of the equity in $1.3 billion of CDOs issued by Credit Suisse Asset Management over the past 12 months, people familiar with the matter said. Elliott subsequently sold the equity to other funds for annualized profits exceeding 20%, they said.
The financial engineering is reviving as U.S. rules governing structured finance deals are being loosened by a combination of regulatory actions and legal challenges. In February, the Loan Syndications and Trading Association—the industry’s main lobbying group—prevailed in a long-running lawsuit that challenged postcrisis rules requiring CLO managers to retain a slice of the deals they put together.
The rule, known as risk retention, now doesn’t apply to CLO managers. Regulators are also revisiting another postcrisis restriction known as the Volcker rule, which has prevented banks from owning CLOs that include anything other than loans. The LSTA is urging regulators to ease that rule by allowing banks to own CLOs that mostly hold loans but can invest up to 10% in junk bonds—a move that could give an extra jolt to the already red-hot CLO market.
Managers of the new CDOs are betting they will outperform the more popular CLOs. Bonds issued by the CDOs pay a fixed interest rate, unlike CLO notes, which pay a floating rate that moves in lockstep with benchmark interest rates. That means that when benchmark rates rise, CDO managers can purchase securities that pay higher interest, while their costs stay constant. That generates more money for equity investors, who receive all gains in excess of the interest paid to bondholders.