Taking on corporate exposure through the credit derivatives market has become one strategy a growing number of CDO investors are embracing. Yet while the credit derivatives market continues expanding, how liquidity performs for single names is a phenomenon CDO investors may not fully understand when exploring new CDO deals that harness credit derivative swaps.

Single-tranche CDOs have gone mainstream this year, and a plethora are in the market right now. Currently, TCW Advisors' Oak Canyon Funding I, a $1.874 billion synthetic CDO lead managed by RBC Dain Raucher is in the market. The deal is packed with investment grade single tranche names. CDC IXIS has shopped around a synthetic $750 million CDO, Blanche CDS 2004-1, which is packed with single tranche credit derivative swaps.

Morgan Stanley's self-underwritten synthetic CDO of high grade ABS, CDOs and single tranche names is also in front of investors - CoRDS 2004-5 is a $2 billion dollar vehicle, sources said. Morgan Stanley also has a smaller $48 million synthetic CDO, Elva Funding 2004-7, in the market, which is comprised of single trance ABS synthetic collateral. Finally, Barclays Capital is the manager of Vantage 2004-2, a $2 billion single trache investment grade backed CDO. Sources said the $60 million triple-A rated A tranche had spread talk of three-month Libor plus 60 basis points.

Single-name credit default swaps have increased 100% year-over-year to $1.9 trillion, and comprise roughly two-thirds of the credit derivatives market, according to Fitch Ratings. However, in studying the single name marketplace, analysts found that liquidity has evaporated for distressed names, and that liquidity wasn't exactly a guarantee of the marketplace when it came to name-specific trading volumes.

Alongside the current uptick in the credit cycle, the CDS market has expanded and expansion has led to an increase in bid levels. The overall number of quotes and reference names traded has increased as well. But name specific trading volumes (not to be confused with traded indices or the bank-to-bank market) are not as robust as they appear on the surface, particularly during periods of stress.

The CDS market is subject to structural imbalances, "as protection buyers often outstrip protection sellers," Fitch analysts contend in a Nov. 15 report, Show Me the Money.' Analysts found liquidity was hindered during turbulent times, such as the July 2002 credit downturn, when protection sellers evaporated for certain names. "Investors looking to buy protection outnumbered investors willing to sell protection by a margin of almost 2.5 to one," the report notes.

Market imbalances create other liquidity issues during down credit cycles. Fitch analysts looked at reference entities that traded at their widest levels during the second and third quarters of 2002 and then determined how much time it took before the name was quoted again. "Nearly 40% of the names in a sample of the top 250 most active reference entities were not quoted for four or more weeks after reaching the maximum bid level," Fitch said.

A portion of the structural imbalances were attributed to the market's history as a hedging tool for banks, analysts said, a legacy that persists despite growth in two-way trading activity by hedge funds and others. But overall, Fitch analysts were confident that these liquidity issues were due more to a still maturing marketplace. As the market develops, more players are seen entering the market and the number of bids and offers will smooth out during periods of credit stress.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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