While the CDO market continues to roar along, investors and managers alike are trying to deal with a tight spread environment. Existing CDOs are particularly challenged, noted panelists at last week's ASF 2005 Conference.
"CDO managers are coming back with a desire to amend their spread tests," said Moody's Investors Service Senior Vice President David Teicher.
The premium once found in using new CDO managers has also eroded away, creating little-to-no gain on that strategy, added Ira Wagner, senior managing director at Bear Stearns. Equity return targets are also changing.
"In a market like this, you want to stay selective," said Ron D'Vari, managing director at State Street Research & Management. "You don't want to sacrifice your credit quality just because of tighter spreads."
D'Vari noted that the struggle for CDO managers in the current tight spread environment sometimes requires deferring from the initial investment plan. He relayed an experience in managing a vehicle that was ramped up just as spreads compressed. "By the time we got to the market, the spreads had reversed. We have to manage the vehicle not by what was realistically promised but what makes sense going forward," D'Vari added.
Teicher noted he has seen a number of structural innovations, including digital credit default swaps.
"We have seen use of the CDO structure for term, non-recourse financing for new asset classes such as equity-default swaps and municipal bonds," said Wagner. Also, an emergence of investors asking for high-yield synthetic CBOs has been felt, he reported.
A movement is underway to "look at alternative equity investments that make sense in this market," said Deutsche Bank Securities research strategist Anthony Thompson. "but I always worry if another hot' equity will come along," he said. Healthcare or technology coming back into CDO equity would be a sign of concern for Thompson.
A rising interest rate environment can also lead to greater corporate defaults, as borrowing costs rise. "We have to be sensitive to that going forward and be mindful of how that effects real estate," added Thompson. He noted the emergence of home equity deals with 20% to 30% of IO collateral last year and speculated that investors might be "reaching for assets that may be the telecom of three years ago."
Moody's Teicher also noted that correlations among synthetic corporate CDOs are quite high, something investors need to consider going forward.
State Street's D'Vari agreed in regards to the increased correlation risk in the market expressing a lack of belief that rating agency models had not picked up on correlation.
Investors were reminded that all CDO collateral classes, at one time or another, staged great performances for short cycles. Therefore, the winning strategy is to realize different structures come to the market at different times. A diverse, broad CDO investment strategy was advocated as some market participants worried that the market is overheated.
"Highly speculative structures...we don't participate," quipped D'Vari. "Don't overshoot, be patient. A year from now, you can make up for lost time."
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