Moody's Investors Service last week unveiled a new service aimed at helping a burgeoning class of U.S. cash CDO equity investors - mostly hedge funds - track how well their investments are performing. The rating agency will begin providing monthly reports, called the Moody's Equity Score Report,' on such indicators as internal rate of return, dividend and yield distributions and the most recent year's equity payment. In the first release of this report, Moody's analysts found that emerging market CDO equity pieces yielded the highest returns compared to other asset classes, while high yield CBOs were more likely to disappoint their investors.
"If someone is looking to invest in CDO equity going forward, I think that until now, they haven't really had a comprehensive data set to benchmark their prospective returns - those that are being promised and marketed," said Moody's vice president Natasha Chen. So far, the Moody's data does not incorporate factors influenced by market value, such as purchase price and liquidation value. While investors will need to factor in the information themselves, Moody's is planning to bulk up its equity data over time to include a deal score for each equity tranche, par and interest coverage test data and reason for deal termination. The rating agency also plans to reveal the names of every deal that it tracks.
Performance data for CDO equity tranches can be difficult to find because they are generally a portion of privately placed deals, and the rating agencies generally do not rate them. Nonetheless, a hunt for yield throughout the structured finance market coupled with the relatively benign credit environment of recent years has sent a rash of new investors to the space. While both projected and historical return-on-equity data is available to the market in various forms, the move by Moody's constitutes the first rating agency attempt to consistently chronicle the information.
The sample tracked
The new report tracks 603 CDO equity pieces issued from 1996 through 2004. The sample represents more than 90% of outstanding deals, according to Moody's Managing Director Gus Harris. The most likely candidates for poorly performing equity were deals that buckled under poorly performing collateral, resulting in early pay-downs for senior tranches, and those that contained tranches which were not paid in full.
Tracking 66 transactions that had terminated, Moody's found a range of internal rates of return from negative 82% to 99%, with a median return of negative 0.05%. One-third of the deals had positive, double-digit returns. Tracking the returns of terminated transactions provides a complete view on returns, since those that have yet to terminate often show negative returns because they have yet to receive all of their payments. For the terminated deals, the rating agency found that arbitrage cash flow CBOs had a negative 19.5% rate of return, on average, while their investment-grade counterparts enjoyed an 11.1% rate of return. The sample size for these classes, however, was 14 and two, respectively. Eleven emerging markets CDOs tracked showed a 1.6% average rate of return, and 32 arbitrage cash flow CLO deals showed a negative 2.6 rate of return.
Looking at CDO equity returns over time, the rating agency found that an often-stated characteristic of CDO equity cash flows - that they are widely front-loaded and earn the bulk of returns within the first three years - could be misleading. While CBO deals tracked by Moody's did receive their bulk of returns within the first three years and peaked at year two, emerging market CDOs earned their highest returns in year seven. Other classes of CDOs tracked - CLOs, re-securitized CDOs and investment-grade CBOs - comparatively demonstrated a more even rate of return across the seven-year timeframe captured by the rating agency.
Front-loading returns
Still, for CDOs backed by assets expected to show higher rates of default with time, it is a commonly held belief that returns will be front-loaded. Moody's data shows, for example, that high yield CBO equity tranches yielded a 30% total cash return in year two before dropping steadily to bottom out at a 2.5% rate of return in year six. Similarly, using its own models to assume loss, prepayment and delinquency projections for subprime loans, Citigroup Global Markets analysts found last month that most subprime bond defaults will be back-loaded, creating a relatively long period of time before losses are realized (ASR, 03/22/05). They recommended that would-be equity investors seek out a well-managed deal backed by a geographically broad pool - and a rate of return in the range of 20%. Of course, the timing of the cash flows and their size are primary factors in the viability of the investment as well.
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