Junk Bonds Turned into Investment-Grade Securities

Article excerpt

Investment bankers looking to inject life into a moribund market are pushing one of Wall Street's more novel repackaging ideas: turning junk bonds into investment-grade securities.

The collateralized bond obligation, or CBO, has grown from scratch into a multibillion-dollar market in two years.

Some bankers think the market's size could double this year alone, and in the process bring some fresh demand into a junk-bond market sorely in need of buyers.

``I think it has some potential to grow because what it does is put bonds in the hands of long-term holders,'' said Timothy P. Norman, a vice president at Duff & Phelps Investment Management, which manages more than $25 billion from its Chicago offices.

Norman manages one of the biggest CBOs done to date, a $301 million deal completed last November.

The concept, he said, is sound even if the idea of turning junk into grade-A investment material seems like financial alchemy.

The CBO pools bonds issued by a number of different companies to minimize the risk of defaults. Then, it apportions interest and principal payments flowing from the junk pool to several tiers of investors.

The top tier or tiers has first priority to payments. Only after they receive their interest and principal does money trickle down to investors at the bottom tiers, where the risk as well as the potential returns are much greater.

``You're able to take a pool of junk bonds and basically carve the risk up and sell it to a buyer who wants a part of it,'' says Andrew Kimball, an associate director who helps issue ratings for CBO deals at Moody's Investors Service.

In Norman's case, Duff & Phelps bought just over $300 million of junk bonds, repackaged them under the name of D&P CBO Corp. and then sold off stakes of the pool to four classes of institutional buyers.

The top tier, totaling $240 million, got a solid single-A rating from Standard & Poor's Corp.

Investors buying into that tier - mainly insurance companies - were promised a return of 10.05 percent over an average life of seven years. That was a little more than 1 percentage point above the yield on conventional single-A-rated corporate bonds at the time the deal was done, Norman said.

The next level, having a subordinated claim on payments from the pool, totaled $45 million and was priced to yield about 13 1/4 percent, Norman said. …