Are investors ready to take on corporate risk again? Judging by the recent attention that high yield-backed CDOs have received in the European market lately, it appears as though the capital markets are beginning to stabilize. However, the market is probably not ready to turn the corner yet, sources say.

Still, the changing tides are noticeable, even if they are only significant in relative terms. Two months ago, investors were largely expected to steer clear of corporate-related paper, but in the past weeks people were slowly trickling back into the secondary market.

"CDOs will get attention because [they are] looked at by many market players as a bellwether on how the corporate bond market looks," said one syndicate trader. "And what we have been seeing is trading of cash, fully funded CDOs - these have been getting better attention; but I wouldn't say that the market is largely positive for CDOs in general."

Investors are apparently largely in favor of managed CDOs backed by loans, attributable to the superior performance of loan deals versus bond deals, said bank analysts; but even in CLOs there is distress to be uncovered, they warn.

Still, as Dresdner Kleinwort Wasserstein reported in its monthly publication, managed arbitrage CDOs in 2000 and 2001 containing large concentrations of high yield bonds exhibited relatively higher levels of distress, some piercing the 5% ceiling in the triple-C bucket, which results in restricting the manager's trading flexibility because assets are typically traded to improve pool quality.

For example, last week Fitch Ratings downgraded three tranches of Eurostar II as follows: Class A-3 to A-' from AA'; Class B to CCC' from BBB-; and Class C to CC' from B'.

According to Fitch, there was futher deterioration in credit quality of the portfolio. In the past six weeks the portfolio has suffered four defaults, bringing the total to 13 defaulted assets, which Fitch said has a notional amount adding up to EURO64 million.

The portfolio manager, DWS Finanz-Service GmbH, has sold five defaulted assets, realizing a loss of EURO21.8 million. There are eight defaulted assets that remain in the portfolio. Dresdner explained, "Assuming DWS achieves a similar recovery rate on average, the equity piece [EURO50.5 million] would be completely wiped out once the losses are realized and the capital of the Class C notes would begin to get eaten into."

So with trouble even among the preferred asset types, it would seem unlikely that market participants would be ready to shift to a more positive view of corporate credits, but analysts said that there does seem to be a slight shift that is beginning to develop.

While it is still too premature to judge how significant this change of heart will be for CDO issuance going forward, it definitely sheds light on investors' perceptions of the credit markets. "I wouldn't say that the window has been open instead it's better to look at it as though the blinds have been opened," said the trader. "We have done quite a bit of trading with triple-A rated pieces with accounts that have slowly come back into the market.

"It's the traditional investors, who have never before looked at impaired CDOs, who are making the inquiries," he added.

Back on the primary front, last week Pacific Investment Management Co. (PIMCO) priced its EURO321million-managed arbitrage CDO, which was led by Deutsche Bank. The class A1, B and C notes, totalling EURO248 million, were privately placed and four smaller tranches were publicly placed. "As CDOs are more difficult to place we are seeing more deals structured in response to investor requirement," commented analysts at Dresdner.

But it's still too early to judge how other structures could fare going forward, as there has been very little opportunity for variety in the market lately and market participants will likely hold out and test the waters. "There has definitely been some progress, but as the economy comes up you will still experience some lag in defaults that could span another six to nine months at least," said one source.

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