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Tuesday, June 07 2011 | 11:40 AM
Robert S. Sainato CFA, CFP, CIC, CAIA
Managing Director, Structured Credit & Mortgage Group,
ADVISORS ASSET MANAGEMENT
|TruPS CDOs: Positive Convexity for Seniors, Mezz Tranche Optionality?
The TruPS CDO Market continues to underperform all other CDO markets to date, but this could change as soon as this year. We believe that certain TruPS CDO tranches could start to outperform due to substantially shortening WALs. At present, the market is assuming 0% CPR, translating to very long WALs. The market may be significantly overestimating the WALs of certain 1st priority tranches, especially if prepayments increase due to increased M&A activity, refis, and the Collins Amendment (see below). This effect could be even more pronounced in deals that have older bank TruPS paper in it.
For certain mezz tranches that are currently PiKing (those with only 1-5% negative OC cushion), we are bullish on certain cuspy tranches that may turn on in the future. The catalyst driving this is the new trend of deferring TruPS paper starting to pay again (see below). A careful fundamental analysis of the underlying deferrals could reveal significant upside in these cuspy TruPS CDO mezz tranches, as only a small number of deferral cures can greatly affect your return on these tranches.
Bank TruPS CDO Quotes (Assume 2005 or later)
Potential Increase in Prepays on the Horizon: M&A, Basel III/Collins Amendment, and Refis
Over the past six months, a new positive trend emerging is a pick up in M&A activity among small banks. Recently Iberia Bank took over ailing Omni Bank. Omni TruP debt, although paying at the time, was effectively prepaid.
Last year the Collins Amendment and Basel III passed, resulting in the loss of bank trust preferred debt TIER I status. This could result in many TruPS getting called beginning in 2013. Under the Collins Amendment, phase out of trust preferred Tier 1 credit begins in 2013 and ending in 2016. Although few banks have called their paper yet, this is likely to pick up in the near future.
Many older TruPS CDOs (pre-2006) hold bank TruP debt, strong with a high coupon. Some of these banks can easily refinance some of their paper. As defaults and deferrals continue to bottom and the new issue market picking up, we could see a significant number of banks prepaying.
Deferrals Beginning to Pay Again
Between M&A, new equity capital from third parties, and improvement in banks' asset quality and liquidity needs, we are seeing a number of issuers that were formerly deferring curing to pay again (see example list below). Corporate activity and equity injection have been major reasons for cured deferrals. In these cases, the new equity capital is received either through acquisition or injections from third parties. When this occurs, the deferred TruPS interest must be repaid before the new investors/holding company can be paid. Still, other banks are paying again due to better performance. For example, Inland Bancorp Illinois and Lawson Financial Corp (deferring TruPS) cured due to better performance (not M&A).
Some examples of banks that were deferring and have been since cured can be found below.
Tender Offers: A New Trend
Last year there were several requests for noteholder consent from distressed banks to tender their securities. All requests until this January have been denied. According to Fitch, they have received notification of the first tender offer ($20 bid) that was accepted. This is the first successful tender offer we have heard of and may be the start of a new trend. These types of transactions need to be analyzed carefully as it may or may not be beneficial to noteholders.
Optionality Down the Cap Structure
Some original AA-A rated PiKing paper has been underwater (negative OC Cushion) due to deferrals and defaults. Many of these tranches are underwater between 1%-10%. For those tranches that are "at the money" where they are only underwater by between 1-5%, there could be significant opportunity here. Given the trend in some bank deferrals curing, potential refis (especially on older deals), M&A activity, and slowdown in new deferrals/defaults (see default/deferral index below) there may be some tranches that get turned on in the coming months or years. If these tranches start paying again, returns could be extremely significant.
Swap Drag--Significant Drag on Deals but Should Improve Over Time
Hedge drag has been a significant factor hurting interest cash flow to date. Significant asset deferral/defaults combined with the low level of LIBOR have impaired many tranches. These imperfect hedges to date have been problematic, but it is important to note that as time goes by hedges "roll off" and as LIBOR rises (eventually), this mismatch may even help the deal (if LIBOR rises enough). Under the right circumstances, this problem now could reverse itself!
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