The CDO market has apparently become disenchanted with high-yield bonds, as more and more CDO managers are turning away from junk in favor of less-volatile collateral like asset-backed securities.

In first-quarter 2002, ABS and commercial mortgage-backed securities contributed more volume to new CDOs than junk bonds, which is the first time in market history that has happened, researchers from Deutsche Bank Securities said. Further, only one new entirely high-yield CDO has been issued so far this year-a far cry from the junk CDO market's heyday. For example, 15 new junk CDOs were issued in the first four months of 1999 alone.

Market players said that the shift indicates a growing fear among CDO managers that high-yield bonds, especially those hailing from the late 1990s, are becoming too toxic to risk using as collateral.

The CDO market has a growing asset quality problem, which is starting to worry investors who flooded the market last year, in part due to worries about volatility in the equities and lower-rated bond markets. CDO woes have exploded on their own right, with more downgrades so far this year - roughly $12 billion - than the $6 billion posted for all of 2001, and far more than the $1 billion for all of 2000.

"The erosion of CDO asset quality has expanded both in terms of geography and in terms of credit rating," wrote Anthony Thomson, managing director of securitization research for Deutsche, in a recent report.

As a result, many CDO issuers have begun crossing high-yield bonds off their lists for new deal collateral. About $14.5 billion in new CDOs were issued in the first quarter, of which ABS/CMBS made up roughly $6.1 billion, junk made up $4.5 billion and investment-grade bonds made up about $1.2 billion, among other sectors, Deutsche researchers said.

What happened?

One bond investor said that the high-yield bond market, which has had a strong year so far in terms of new issues, could be hurt by this trend in the CDO sector, as junk bond issuers and underwriters have come to expect a good portion of a new issue to be funneled into CDOs. If the high yield CDO bid drops, that could have pricing and liquidity implications for the junk bond market.

Many of the troubled deals come from the boom years of 1998 and 1999, when, as Thomson said, "CDO issuance was growing faster than that market infrastructure necessary to analyze it."

The CDO market and the junk bond markets had the happenstance, and ultimately the misfortune, to be going through massive issuance booms at the same time, and as a result, the flood of new junk bonds - hailing from the telecom sector, where underwriting criteria was subject - fed an equal hunger for new junk bond-backed CDOs.

In some cases, CDO managers without a lot of corporate market experience were using basic statistical models to predict default rates and performance assumptions for their deals. Of course, this type of statistical approach works best with assets whose performance is predictable, such as high-rated ABS and mortgage-backed securities. Such an approach, safe to say, did not predict the junk market's wild swings in the past two years.

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