The credit quality of high yield CDOs, particularly at the senior level, is improving, Merrill Lynch reported last week in research.

A recently issued surveillance report from the firm tracked deal performance and coverage test status of 35 Merrill CDO transactions; deals tracked in the report were primarily high yield bond and leverage loan-backed.

"There is clear evidence that credit quality in the CDO market is improving," Merrill Lynch Managing Director Dan Castro wrote, citing information from all three rating agencies. Moody's posted its slowest pace of downgrades since 3Q 2001 - 80 tranches downgraded from 40 deals - and it upgraded two tranches; S&P downgraded 64 tranches on 31 deals and it upgraded five; and Fitch downgraded 87 tranches in 28 deals while upgrading 47 tranches from 14 transactions.

According to the research team, one of the developing trends has been mixed rating actions on a transaction, pointing out a 1998 vintage high yield bond CBO transaction CAM CBO I as an example. Having previously experienced several downgrades, a mix of actions occurred in September via S&P. While class A notes were placed on review for upgrade, class B notes were placed on a negative watch. So on one hand, while the CBO's class A notes saw an improved O/C ratios due to de-levering, the O/C ratio on the deal's class B notes were hurt by new defaults in the portfolio. "We expect to see more mixed rating actions in the future as distressed CDOs de-lever and collateral credit quality remains uneven," the report noted.

Of the 35 deals tracked, just three had downgrades last quarter: ML CBO Series 1997-C-3; PPM America High Yield CBO II Class A-2; and ML CLO series 1998-Delano-1.

Primary market

While older vintage deals continue to barbell, new-issue investors are indeed lapping up high yield-backed CDOs, as evidenced by a record volume last month. Roughly $5 billion of high yield loan-backed CDOs were distributed in the primary market, a record high for the year, according to UBS.

"Some structures are ameliorating tightening loan spreads by fitting revolving loans into their deals and giving CDOs longer ramp-up periods in which to find the right collateral," the firm noted in its piece.

Spreads for high yield CLO/CBOs at November's close ranged from 50 basis points to 65 basis points at the triple-A level, compared to a range of 53 to 67 posted at September's close, UBS reported.

The picture is less promising for the entire CDO market, compared to the high yield-backed segment, which really only had one direction to go. UBS researchers found that structured-finance CDOs are showing ratings volatility, combined with tightening spreads in collateral markets.

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