Analysts at Standard & Poor's found that the largest increase in CDO upgrades since 2002 occurred last quarter, but the news was tempered by a sizeable level of downgrade activity. However, the third quarter spelled good news, overall, for the high-yield bond sector.
In the third quarter of 2004, 16 tranches of 10 cash-flow and synthetic transactions were upgraded, topping a record of 11 upgrades seen in 2Q02. Of the 10 transactions, five were high-yield CDOs, four were high yield leveraged loans and one was an ABS CDO structure. But the positive news is more the sector's stabilization than a strong comeback, as 36 ratings downgrades were recorded for the third quarter.
"The rating actions are still overwhelmingly weighted in favor of downgrades. But you can find certain asset classes within which there are more upgrades than downgrades, such as high-yield bond deals," said S&P Analyst Stephen Anderberg. At the end of the third quarter, 20 high-yield bond CDO ratings were on S&P's credit watch positive compared to four on S&P's credit watch negative. "That indicates to me that over the next quarter, as a forward looking indicator, you're going to see a lot more upgrades than downgrades on those deals," said Anderberg.
As expected, much of the downgrade activity last quarter stemmed from CDOs of ABS, due to the poor performance of the manufactured housing sector, EETCs and some subordinated CDO tranche holdings within the CDO of ABS collateral pools.
Unlike years past, high yield bond CBOs were not the usual culprit last quarter when it came to downgrades. In all 18 ABS CDOs saw were downgraded in the third quarter compared to eight high-yield bond CBOs.
"What happened is, as the economy has improved and as the CDOs have started to delever - or pay down their senior tranches - since they're reaching the end of their reinvestment periods, these transactions are now actually dominating the upgrades," added Anderberg. "A lot of the senior tranches within these previously downgraded high-yield bond deals are seeing upgrades back towards the original [new issue] ratings."
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