New issues in the domestic CDO marketplace have declined sharply in recent weeks, prompting speculation that more than just downgrades are clouding the sector's vigor and clogging up the pipeline.
While April saw a total of $6.38 billion in funded new issuance, last month that figure had dropped to $2.42 billion as of May 22, according to JPMorgan data. Moody's Investor's Service stated that CDO issuance "nose-dived" by 30% in the first quarter, compared to the same period in 2002. Rated volume in 1Q03 totaled just $6.0 billion, less than half of the $13.7 billion rated one year earlier. Moody's Jeremy Gluck, managing director at Moody's, predicts the annual U.S. volume will fall short of the pace set in 2002.
Figures from Fitch Ratings concur. As of April 30, just 32 new CDOs hit the U.S. market for a total volume of $34.4 billion, according to the firm. To lend an idea of last year's pace, 2002 saw 170 CDOs, according to Fitch.
The sky isn't exactly falling in on new issues, several sources said. At the core of the blockage lies a relatively new phenomenon - mainstream investors have honed in on CDO secondary market trading, marking the first time activity on the back-end has overshadowed new issues.
"There's a pretty active (secondary) market this year, which is different from the past. The trading of distressed CDOs - whether they're downgraded tranches or not - has taken place more prominently over the last six months or so," said Christopher Flanagan, head of research at JPMorgan Securities.
The glut of downgraded paper that has accumulated over the last two years has resulted in arbitrage fire-sale opportunities. Thus, many new deals in the CDO pipeline remain stuck simply because they can't compete to where trades are taking place on a revved-up secondary market.
Slowly buckling under the weight of downgraded paper, certain investors simply tired of holding, Flanagan explained. "They've been accumulating these (downgraded tranches) and a lot of people just began to start selling, finally," he said.
"There's definitely a siphoning off of interest from the new issue market into the secondary market," agreed Gyan Sinha, managing director, Bear Stearns. Given some time, Sinha stated a convergence should occur between the two markets, with new issues creeping out and secondary spreads tightening in. "The secondary market is going to save the new issue market," he said.
According to secondary market sources, the majority of trading activity taking place involves corporate high grade, high yield, emerging market and CLO deals. Multi-sector asset backed CDOs are not trading that actively on the secondary market.
"It's all about the net asset value (NAV) of the deals," said Armand Pastine, principal and co-head of structured products at The Williams Capital Group. "Multi-sector asset-backs aren't trading that well because most of the CDO players are having a difficult time pricing the underlying collateral. It may take you two or three days to do a NAV on a deal - and you may not be right."
Better than 90% of all secondary activity centers on collateral of the corporate nature, according to market pundits. Investors have a sense of the price perimeters of those underlying assets and correlation assets, and additional help to quantify these credits is offered by pricing services, Pastine explained.
Reportedly, CMBS, namely residential subordinates, have also been well bid and trading efficiently, secondary market sources said.
"They're the best performers in the market because of their stability in the underlying collateral, to the extent that they're trading the closest to new issue spreads than anything else that's out there," said Pastine.
As a result of this increased interest, concessions in the secondary market have narrowed over the last six months. Traditionally, the pickup between a new issue tranche and one on the secondary market was between 15 to 20 basis points. Today that spread differential could be as little as five basis points, in some cases tighter relative to where new issues are pricing, particularly if the tranche is clean, triple-A credit. "That's the way things should work. Secondaries are tightening in, and eventually we have to settle into an equilibrium," Bear's Sinha said.
Currently high yield is seeing the largest impact of this twist in CDO buying habits. Asset yields have come in about 200 basis points since November 2002 and liability yields are in 12 basis points, Sinha said. Therefore the net spread has compressed from over 730 basis points down to 490 basis points, he noted. "We haven't seen a dramatic recovery like this since, probably, the early 90s," Sinha said.
Other sectors have experienced spread movement in both directions over the past several months, including investment grade (IG), structured finance (SF) and synthetic CDOs. According to data from JPMorgan, spreads on triple-A IG deals, with a WAL of seven to nine years, have drifted out from 68 basis points in late December 2002 to 72 basis points on May 22, 2003. During the same time frame, SF triple-A tranches, with a WAL of seven to nine years, have nudged out from 65 basis points to 67 basis points while synthetic triple-As, with a WAL of five to eight years, have come in to 90 basis points from 95.
While spreads are an indicator of prices in the secondary market, Pastine called attention to the correlation of defaults in the high grade market. "The problem is that the correlation of defaults is a lot higher. While spreads have come in, which is true, the correlation of defaults have gone higher," he said.
Overall, general market sentiment appears to be if Chicken Little is chirping about the sky falling in on collateralized debt obligations, he's still making the same inaccurate calls.
The market remains strong, analysts say. Year-to-date global funded volume is $29.5 billion, according to JPMorgan, on track with the $30.8 billion for the same period last year. Much credit is due, however, to the European CDO marketplace, which has churned along while the U.S. market has slowed. Of the six visible pricings during the week of May 19, just two were in the U.S. market. This has been a typical week for the CDO market, sources said, since April tailed off. "The secondary market is going to save the new issue market," Gyan Sinha said.