Collateralized Debt Obligations: Structures and Analysis, Second Edition

CHAPTER 9

Emerging Market CDOs

Many portfolio managers have invested a substantial amount of time and energy in understanding CDO structures. Most have become comfortable with CDO deals backed by both structured finance collateral and high-yield bank loans. However, these same portfolio managers are still quite uneasy about any CDO backed primarily by sovereign emerging markets bonds, as they believe that all emerging market debt is tainted by high default experience.

In this chapter, we shed some light on the differences that matter between emerging markets and high-yield deals. The picture that “emerges” (pun intended!) may surprise you—positively, that is—for the following reasons:

• There have actually been few defaults on U.S. dollar denominated sovereign Emerging Market (EM) bonds. The negative bias of many investors against EM CDOs is because they do not fully appreciate the differences between EM sovereign bank loans and EM sovereign bonds.
• Rating agencies are far more conservative in their assumptions when rating emerging markets deals than in rating high-yield deals, as performance data on EM bonds is far more limited. So there is an extra credit cushion already built into comparable credit levels.
• EM CDOs generally provide much greater structural protection, as the average portfolio credit quality is higher, resulting in a lower probability of default on the underlying portfolio. Subordination on EM deals is also much higher, hence the equity itself is much less leveraged. ...