Last week IFR Asset-Backed Securities Senior Analyst, David Graubard, spoke with award-winning Street analyst and head of Bear Stearn's CDO research team, Tracy van Eck, and team member Eric Banks, who is a former CDO trader. The two share Bear Stearn's view on what the market has learned from the relentless number of downgrades in the high-yield sector, current macro-economic challenges, and what the future holds in store for CDO investors and practioners.
DG : Where is the lagging U.S. economy affecting CDO performance aside from rating volatility, certainly the HY CDOs have taken some hits?
Bear: Clearly the lagging economy has affected HY companies and the default rates we've experienced over the past couple of years are an indication of that. Probably a greater contribution, however, stems from the irrational exuberance seen in both the stock market and the debt markets in 1997 and 1998. Nearly all the recent defaults are either from deals done during that period or telecom issues. Access to capital has dropped dramatically and has impaired many of these issuers in a more serious long-term manner.
DG: Investors are always looking for bargains. Are some people finding an upside to the poorer performing CDO cohorts?
Bear: Absolutely. Anytime there are huge disparities in performance, there is a certain contingent of the investor community who cannot own deals with any headline risk. Some investors, on the other hand, have the luxury of being more opportunistic and completely value driven. Value based CDO buyers who are making the effort to develop an understanding of various secondary market analysis tools are reaping the benefits of this market.
DG: How will CDOs perform if the economy continues to deteriorate over the next 24-months?
Bear: It's not obvious to say that if we see the same economy we have just experienced over the past two years, with respect to default rates, that the performance of the CDO market will be as poor as it has been. Newer transactions have performed better already than those issued in 1997 and 1998. In addition, CDO issuance is far more diversified than it has ever been. The number of ABS and high-grade corporate transactions is still growing. If default rates do not decrease in the HY market, it should not imply that the performance of other credit markets will be poor as well.
DG: What's cheap right now?
Bear: On a relative value basis, new issue triple-A tranches, priced at L+40-50, continue to be cheap when compared to alternative triple-A rated investments. In addition, we believe there is value in the senior classes off of poor performing deals. Credit enhancement levels continue to be strong, and interest payments cannot PIK, yet these bonds trade at extremely discounted levels given their actual credit risk. Furthermore, the perception of poor management is one of the reasons why these transactions trade at such wide spreads. Ironically, when a transaction is distressed we can reasonably expect that the portfolio will be virtually static since the manager has very limited trading flexibility.
DG: The news that American Express took such a big hit on its CDO investments surprised many senior managers, are you hearing of any continued impact from this headline event?
Bear: Ironically, we are seeing more new entrants into the market than investors leaving the market. We are still enjoying a global expansion in many of the U.S. fixed sectors. It is true that some CDOs have performed badly. That does not mean the market is a bad idea. EITF 99-20 played a big role in the announcement from American Express. Almost all insurance companies are having to essentially mark-to-market previously held-to-maturity portfolios. In the long run, EITF will serve as a catalyst for more trading.
DG: How's the arbitrage for cash-flow investment grade CDOs; many sponsors appear to opting for the managed synthetic IG CDO like the Chambers Street deal Bear did for the Clinton Group?
Bear: The creation of the un-funded super-senior market is the primary reason for why an arbitrage exists in the high-grade CDO market. Although the economics for this sector of CDOs still work, spreads have tightened significantly on the collateral side relative to deals that were done back in December of last year. For a portfolio of triple-B swaps, the net spread earned as of last year-end was roughly 100 bps, and currently is closer to 85 bps. Current trends seem to show that the loan market is particularly cheap right now, with respect to CDO execution.
DG: If an investor were to diversify their CDO investments, while seeking the best total return in triple-B bonds and above, what would say would be the model portfolio?
HY 30%; ABS & HG 30%; Loans 30%; We're sure that some people would be surprised that we would keep such a high proportion in high yield given recent performance. We think, however, that this may be the best time to consider high yield CDOs.