Mention high yield to someone in the CDO market, and you'll likely elicit a negative reaction. After all, high yield has been the least favorite asset class for CDO collateral over the past couple of years, as a result of the record defaults and rating downgrades the sector has experienced.

But that might be about to change, according to Sivan Mahadevan, head of credit derivatives and structured credit research at Morgan Stanley, who spoke at the Bond Market Association's first annual CDO conference in New York last week.

Mahadevan believes that the double-B rated section of the high yield universe could be making a comeback as CDO collateral. There is also anecdotal evidence to suggest that several structures are currently ramping up with double-B rated credits.

If that is indeed the case, then things have certainly changed, because high yield bonds have not really been in vogue since 1999. Back then, they accounted for 42% of the underlying collateral used for CDOs, while mortgage and asset-backed securities accounted for only 2%. In the past three years, though, the situation essentially reversed itself, and mortgage and asset-backed securities now represent the largest underlying collateral (40%), followed by high yield loans at 27%.

Why the switch?

Essentially, "[CDO] investors [gravitated] towards the best performing products," said Christopher Ricciardi, managing director and global head of structured credit products at Merrill Lynch. The market has experienced fairly dismal performances by corporate credit-backed CDOs and so it is only natural that investors have turned their backs on high yield collateral in recent years.

But if performance is what drives the choice of CDO collateral, then the performance of the high yield market over the past year has been exceptional. Spreads have tightened by 400 basis points and returns have reached an astounding 17.1% year-to-date. Default rates are also on the decline, and the rating agencies have reported a gradual decrease in the number of downgrades taking place.

Since default rates are cyclical, they are inextricably linked to recession, and therefore likely to continue to improve going forward. This is a strong argument for using sub-investment grade credits as collateral.

As a result of the change in sentiment toward high yield, some of the higher-rated sub-investment grade credits have begun to look attractive to CDO managers and there are reports of a pickup in activity in this space.

"The double-Bs are more attractive than other parts of the curve on a spread per unit of corporate leverage basis," Mahadevan said. This additional spread, minus the additional leverage that double-B credits hold relative to the triple-B area of the curve, is interesting to CDO investors, he said.

"Double-Bs also have a historical lower risk of default than the high yield market averages, making them a safer bet as CDO collateral," Mahadevan noted.

CDO investors may also naturally gravitate toward double-B rated credits because fallen- angel credits make up a significant portion of this higher rated sub-investment grade universe. "CDO investors may be more comfortable with the fallen-angel universe, given their exposure to them through synthetic CDO structures," Mahedevan said.

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