The CDO market is witnessing a significant pick-up in trading of non-PIKable (payment-in-kind) distressed mezzanine paper. Hedge funds (or hedge fund-like units within insurance and reinsurance companies) across the globe are driving this recent increase in buying of distressed mezzanine paper and a handful of these shops are setting up distressed CDO funds that are increasing the trading volume in this illiquid market.

An example of a typical offering in the CDO secondary market is a 1999 triple-B arb cashflow high-yield CDO (75% HY bonds/25% senior secured loans) seen at an 87 dollar price to yield 15%, which is similar to a first-loss piece yield on a new issue transaction. Granted, a position of this kind has seen a couple notches of downgrades.

Secondary market buying and selling is global business; i.e. investors in Japan, Korea, Thailand, the Middle East, and even Kazakhstan are starting to participate.

"Last year there was no bid-ask to speak of in the secondary CDO market - a 10% difference doesn't count - but that is starting to change and we're seeing a real market development," said one CDO source.

According to a managing director at a bulge bracket, it is not uncommon for the firm's secondary CDO desk to do two to three secondary CDO trades per day ranging from $10 million equity positions to $50 million of triple-A's.

But with illiquidity comes challenges; it is not uncommon for $50 million to $75 million-area bid lists to enter the market and never trade. This is sometimes because an investor puts out the list to get a valuation on his CDO portfolio or pieces of it other than through the mark-to-market appraisal process via the dealers, which is frequently frustrating for CDO investors. For example, it is not uncommon for a clean new issue CDO to get marked back 10 basis points to 15 basis points from the original coupon, investors report.

"One of my biggest wastes of time as a portfolio manager before I learned the signals of a serious seller, was drilling through bid lists for several days that would simply evaporate," said one CDO source.

Several investors feel dealers are inconsistent, and in their opinion often unfair, about how they are marking CDOs, which has enormous repercussions for the mark-to-market value of an investor's portfolio. "Some dealers are marking positions extremely low, while others are marking way too optimistically," added a portfolio manager. "The only thing that I think investors can do is to have the underwriter explain their methodology for marking a particular bond or push for adjustments when necessary...

"Some will comply while others will continue to mark in a manner that is pretty incomprehensible. On the other hand, while the illiquidity and wide-ranging marks may be frustrating, great opportunities can come out of these inefficiencies," noted the investor.

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