Among other impacts of the deteriorating credit quality in the high yield market - which has subsequently triggered downgrades - the concentrations of triple-C rated assets in collateralized debt obligations have been rising above the imposed structural limits, prompting managers to sell off assets before they're downgraded, according to a report by Standard & Poor's Ratings Service.
Interestingly, with the CDO market at roughly $250 billion - and a substantial concentration of that in high yield assets - so called "haircutting" could be creating an offshoot relative value opportunity, where B-rated assets are being sold at artificial discounts, sources said.
"What you have are structural rules built into CDOs in order to satisfy rating agencies and investors, which are actually impacting a manager's trading behavior," said Glen McDermott, a fixed-income analyst at Salomon Smith Barney.
Further, according to S&P's report, "Such managers have chosen, when faced with weakening credits in their CDO portfolios, to manage the structure,' to the possible detriment of the various investor constituencies. From an investor persepctive, only time will tell if such sales ultimately prove to be an expensive window-dressing exercise."
However, David Tesher, a managing director at S&P, stresses that the CDOs themselves are, in large, performing well, and any impact of the credit migrations should not move above the equity portion on the deals.
Other impacts of a less attractive high yield market has been the notable growth in CDOs backed by securitized products, which S&P dubs, "the newest and highest growth CDO growth sector."
As for the phenomena of the CDO's symbiotic relationship with the high yield market, some analysts suggest that default recovery rates in high yield assets - which have been at depressed levels since 1999 - could in part be impacted by structural guidelines in CDOs.
For example, some CDOs require the manager to sell a defaulted bond one year after default, even if the manager does not think the it's the best way to realize maximum value. Essentially, the case can be made that the structural rules are impacting recovery values.
Furthermore, CDOs often carry defaulted assets at the lessor of market value or an assumed recovery value, in accordance with transaction guidelines, Salomon's McDermott explained.
"What that does is impact bids for defaulted paper that CDOs want to sell, because the market knows that the CDO has to carry these assets at the lessor of market value or, say, 30%," he said. "The bids, not surprisingly, come in at or near that 30% level."
Alongside its research report called "Cash Flow CDOs: After Slow First-Half 2000, Growth Rate to Pick Up", S&P has made public its CDO list dating back to 1994.
