Homeowners aren't the only ones scrambling to take advantage of persistently low long-term interest rates - corporations in record numbers are exercising call options on their unsecured obligations in order to lock in low rates while the window to favorably refinance still exists. The result: high yield CBOs are paying down and performing at record levels, making investors that bought those bonds cheap experience a much greater profit than anticipated.
Standard & Poor's forecasts exercised call options to account for some $22.5 billion in maturities this year and $20.4 billion in 2006. The calls have allowed for huge paydowns, which have sometimes trickled all the way to upgrade even second-priority and mezzanine notes simply because of the excess overcollateralization. The ratio of upgrades to downgrades rose to 2.5-to-1 at the end of the second quarter, from 1.1-to-1 at the end of last year, according to S&P.
"These paydowns will have a direct benefit to senior note holders," said S&P analyst Ramki Muthukrishnan.
With the yield curve expected to revert from its flattening trend in the fourth quarter, paydowns due to exercised call options will be focused on CBOs already in the amortizing phase - primarily the 1997 through 1999 vintages, and account for a significant amount of debt through next year.
Spreads in secondary market trading have reflected the anticipated better performance, traders said. Double-B high-yield CDO tranches continued trading last week at the tightest levels in the last year: 600 basis points over three-month Libor, 170 basis points inside of the year's widest levels, while triple As have shown tightening over the last three weeks, trading at 35 basis points over three-month Libor, about 10 basis points inside spreads for new-issue high-yield triple-As, according to Merrill Lynch.
"Secondary market trading levels certainly take into effect the paydown experience that has occurred, especially in deeply discounted bonds where shortening can dramatically increase yield," said Evan Kestenberg, CDO trader at United Capital Markets. "We have had instances of bonds that were projected to be four-to-six year average life situations trading with 10s of points of discount that ended up paying off or nearly paying off within one year. Consequently, these types of shortening options are taken more seriously and factored into market prices, perhaps too much so."
The David L. Babson & Co. managed Saar Holdings CDO Ltd., which closed in March 1999, has paid down almost half of its class 1 notes - $23.9 million out of $50.07 million - from unscheduled calls since May 2004. The build up in overcollateralization led to senior note upgrades by S&P in June to AAA' from A-'. Similarly, Federated CBO Ltd., closed in April of 1999, has paid down $92.8 million of its class 1 notes since July of last year - $31.9 million of it was due to call options; its senior II notes were raised by S&P to "A" from "BBB+" on April 29.
Sixteen U.S. high yield CBOs were upgraded in the second quarter along, versus only one downgrade - a big turnaround for the investment vehicles, which have a spotty track record because of exposure to poorly performing corporations, such as Worldcom Inc. and Enron Corp. From the first quarter of 2003 leading up to the fourth quarter of 2004, there were only 13 upgrades, versus 163 downgrades. The fourth quarter of 2004 saw 17 upgrades, more than the first three quarters of that year - and all of 2003 - combined. This year has seen 30 upgrades and 10 downgrades through June 30.
S&P expects that 107 CDOs, 75% of which are high yield, will be affected this year and next by at least one bond being called. The only scenario in which an accelerated paydown would negatively affect tranche performance occurs when the mezzanine or subordinate tranche's overcollateralization ratio is materially less than 100%, causing a reliance on excess spread to repay the principal of the notes.
Other factors boding well for currently outstanding CBO performance include the overall decline in corporate default rates, which peaked at 10% in 2002 and now sits 80% lower at 2%, as well as the reduction in CBO swap notional balances amid rising Libor rates, decreasing the over-hedged situation previously experienced.
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