Mezzanine note holders, in particular, need to keep their shields raised in preparation for rising interest rates, especially those with positions in cash collateralized debt obligations. While standard hedging practices crafted by managers and dealers may project out smoothly on paper, market uncertainties have thrown a few "hot pokers" into the mix.

Following a dour 2002, concerns over Bush's economic plan and war with Iraq have hampered the CDO market this year. According to sources, once first quarter figures are tallied, 1Q03 will have been anything but the jumpstart CDO participants hoped for. Researchers at JPMorgan Securities recently reported that CDO returns this year have fallen from the 30% to 40% range to a dreary 20%-25%. By some accounts, year-to-date, CDO issuance this year is 39% off the pace of 2002.

On the sunny side, last week Banc of America Securities noted that internal rate of return for high yield CLOs rose 210 basis points week-over-week, while corporate bond barometers fell. As the first quarter closes, it is much too early to brand 2003 as a lackluster year.

Meanwhile, more information is being sought by investors profiling CDO vehicles during duress scenarios. This, according to one structured financer, is part of the reason CDO pricings have slowed thus far. Marketing periods are taking much longer, as investors take more time to assess information. And new investors rotating in, said the source, appear even more stringent in evaluating a product.

"In the long run it's better for the market. Investors are doing more of the homework," he said.

A rise in interest rates, for example, can create stressful conditions for certain products. But so can the very hedging strategies devised to combat loss. Just a few years ago little attention, outside of a classroom, would have been paid to exploring such a scenario.

In a research piece last week, BofA's Lang Gibson, director of structured credit research, outlined embedded interest rate risk in cash CDOs and concluded that, during a rising rate scenario, it is much better to be overhedged, and vice versa during falling interest rates.

Gibson delved into static and dynamic hedging strategies, using swaps and options, to measure the cash flow impact on a CDO in varying interest rate scenarios. Interestingly, hedging strategies that look good on paper are actually remarkably challenging when put into action.

Most cash CDOs are naturally exposed to rising interest rates as they consist primarily of fixed rate assets, while typically issuing floating rate liabilities. While CDO equity holders are directly exposed to the interest rate hedge cash flows embedded in excess spread payments, mezzanine noteholders, in particular, are exposed to the potential decline in subordination stemming from ineffective hedging strategies.

"At first blush, the hedging strategy might seem fairly straightforward," Gibson notes, "...the challenge... arises from three major unknowns: the precise interest rate profile of the assets established over the reinvestment period; the timing and magnitude of defaults and recoveries; and the amount of prepayments in certain structured product."

Citing the declining Treasury rate and tightening swap spread environment since May 2000, during which the 10-year swap rate fell over three percentage points, overhedging fixed rate assets with pay-fixed swaps would have resulted in cash flow losses, Gibson stated.

Furthermore, CDO managers have yet to bite the bullet, refusing to unwind some of their overhedging that has built up over the last three years.

"Remember, as they do today, most market participants believed over a year ago that rates would have already risen significantly from their lows, which would eventually put their pay-fixed hedges back in the money," said Gibson.

Hedge losses in high yield CBOs have been the most pronounced, as they are typically backed by large concentrations of long duration, fixed-rate assets.

Inadvertently or not, pressures exerted on cash CDOs affect noteholders and equity investors. Gibson cites ineffective hedging risk in cash CDOs as one of the major reasons why investment grade (IG) corporate deals are being executed largely in the synthetic arena. Additionally, multisector CBOs face prepayment and extension uncertainty, and much like cash IG corporate CDOs, hedging ineffectiveness can represent a large chunk of excess spread.

"Unfortunately there's no such thing as a perfect hedge. In reality it is not possible to accurately predict...uncertainties and so the CDO is either overhedged or underhedged or some combination of the two over its life," Gibson found. With Libor apparently hitting bottom, it appears wise to err on the side of overhedgeing at the moment. Alternatively, it might make sense to monetize one's view on rising rates by constructing an off-market swap, Gibson concluded.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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