If you were stranded on a desert island with nothing to do but analyze CLOs, which would you prefer to examine - default risk or prepayment data?

The fact is, many investors are too distracted with defaults and recovery data, ignoring the influence of loan prepayment speeds, say market pundits.

"To look at defaults and not prepayments - you don't get a good handle on the CLO," said Arturo Cifuentes, managing director at Wachovia Securities in a research report titled CLO Equity Performance: The Forgotten Factor, issued by Wachovia last week to shed light on the topic. Manish Desai contributed to the report.

CLOs have garnered much attention this year and not solely because the CBO market has all but ceased to exist. CLOs are performing well as a collateral class, as bank loans have outperformed high yield bonds by wide margins. And overall corporate credit quality has improved dramatically since the lows of 2002.

The report notes that reinvestment speeds do influence CLO performance but it's difficult to say if faster speeds would be beneficial or slower speeds less beneficial. It's neither good or bad, Cifuentes believes, as determining speeds depends on the default levels the collateral is experiencing. Reinvesting at a tighter spread does not dramatically alter the equity return profile.

Of course, bank loans normally repay on schedule, but when placed in a CLO, it's difficult to determine if individual loans are prepaying at a fast or a slow rate. That is a key consideration, particularly in the current market environment. With increased prepayments, CLO managers are sitting on cash, but there's not enough quality loan collateral for CLO managers to reinvest into. With secondary market collateral pricing rich, given all the deals chasing it, managers have turned to second lien loans to compensate.

In the European market, some CDO managers have considered including a distressed bucket in their next funds so that they can better ensure returns for their investors (see ASR 7/26/04).

"In addition to default risk, investors should pay attention to reinvestment risk," Cifuentes said, whose report exhibits several scenarios.

For instance, the report notes the impact of defaults for second lien loans should be examined using "bond-like" recovery rates. Or, under low-default scenarios, one example showed that amortizing senior notes negatively impacted the equity returns. In a high-default scenario, high prepayment speed mitigated the negative effect of defaults. However, managers would not manage exclusively in one strategy, Cifuentes pointed out.

"You want to look at all of the possibilities, consider several default scenarios and several prepayment or reinvestment scenarios," Cifuentes summed up.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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