On average, the asset coupon of a triple-B rated ABS in a CDO portfolio is Libor +175-225 with a funding level of Libor +45-50 on the triple-A rated class. Compare this to a high yield CDO, whose average asset coupon is Libor +275-325 with a funding level of Libor +40-45 on the triple-A rated class. While the spread arbitrage is not as great on the ABS CDO, more leverage may be employed because of the portfolio's higher credit quality. The increased leverage opportunity in the ABS CDO results in comparable, if not greater, expected return on equity. The question is then posed: Does this asset class justify the increase in leverage when used in a CDO?
To date, the CDO market has issued a total of ten transactions that are backed primarily by a portfolio of ABS mezzanine classes for a total of $3.3 billion. We expect issuance of CDOs backed by mezzanine ABS to continue as long as the arbitrage opportunity remains economic. In addition, we expect that ABS CDOs could cause spread tightening within the mezzanine ABS sector as demand for these tranches increases.