As a result of recent negative headlines associated with CDOs (i.e. American Express and EITF 99-20), secondary selling has picked up, as certain portfolio managers are pressured to unload their positions.
In a research report released last week by Merrill Lynch, the firm recommends investors at all tiers of the capital structure to watch for opportunities in the secondary market from zealous sellers.
"News of charges to earnings as a result of EITF 99-20 requirements could alert upper management and shareholders of the losses certain institutions have suffered due to CDO positions," the report says. "In extreme cases, this news could pressure investors to liquidate their holdings. As long as sellers are the motivated players in a CDO secondary market trade, the sector will remain a buyers market."
Still, Merrill does not expect a massive sale by CDO holders unloading positions, primarily because of the market's poor liquidity, and the obvious losses a hasty sell-off would bring. Nevertheless the motivated seller will invariably surface and pose an attractive buying opportunity. The market includes more than just mezzanine and equity sellers, and in select cases a buyer may pick up double-A spread level for a triple-A tranche.
Other CDO analysts have said that some buyside shops are doubtful of a U.S. economic recovery in the near-term and have either already dumped their high-yield CBO positions or are in the process.
"The rise in speculative grade defaults has led to par losses on CDO assets that are impossible to hide behind," Merrill's report said. "Equity investors subject to EITF 99-20 have probably been recording charges on most of the highly seasoned transactions. For these investors, EITF 99-20 could lead to more earning surprises as equity must be written down but then can not be written back up."
Interestingly, the report notes that despite these pressures to liquidate CDO positions, spreads of new issues continue to tighten.
"The support provided by investors not subject to EITF 99-20, such as offshore investors, and ABS CBOs buying behavior, could be a contributing factor to the tightening," the report said.