High yield CBOs - which comprise less than one-quarter of the broader CDO universe - accounted for close to three-quarters of materially impaired securities in the U.S. CDO sector between 1993 and 2003, according to a report from Moody's Investors Service.
Moody's analysts maintain that the poor corporate credit environment is not necessarily to blame, and point to the adverse selection of collateral assets and the sidestepping of structural features by some collateral managers, interest rate risk over-hedging and insufficient structural protection against credit risks as some of the root causes behind underperformance in the HY CBO arena.
During the 10-year span covered in the study, 262 of the 2,719 securities totaling $247.1 billion included in the sample were materially impaired, representing a lifetime impairment rate of 9.6%. However, by original balance, the impairment rate was only 3.2%, since larger securities tend to be higher rated. Of the 262 impaired tranches, 254 had suffered payment default as of last June. In dollar volume, HY CBOs made up roughly 59% of all impaired CDO securities.
Distress among high yield issuers was severe during this time frame, particularly from 2000 to 2002. It was not unlike the high-yield market collapse witnessed in the early 1990s, however, analysts noted in the report. "Given that the earlier wave of defaults had occurred only a few years prior, one might reasonably have expected that the investment-grade HY CBO tranches issued in the late 1990s would have been structured to better weather the 2000 to 2002 corporate default experience," the report said.
Yet HY CBO performance would indicate otherwise. In fact, the average performance of CBO collateral during this period may even have been worse than the performance of the high yield bond market overall.
Assuming default, most impaired securities will likely sustain final severity rates comparable to those suffered by defaulted corporate bonds, the report found. "The average final loss-given-default rate will be about 59% of each security's original balance across all defaulting securities, with the average loss-given-default rates being lower for investment-grade securities and higher for speculative-grade securities," analysts said.
Three-year cumulative loss rates and three-year loss-given-default rates are estimated to average 12% across the CDO securities included in the report. That figure falls to 5.5% if HY CBOs are excluded.
Moody's expects CDO impairment and loss rates to continue to decline in the near term, due largely to improved performance in the corporate sector and new structural features built to reduce the manager's incentive to adverse asset selection. "However, the performance of CDOs backed by certain types of asset-backed securities is expected to deteriorate due to the poor performance of the structured securities backed by manufactured housing loans, franchise loans, aircraft and equipment leases," Moody's analysts said in the report.
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