Despite the prospect of a further weakening economy and the revaluation of all fixed-income products, new-issue CDOs have so far remained relatively unscathed, indicating the product is less affected than comparably rated corporates. Triple-As have widened two to five basis points (L+43-46) on upper tier deals, and ABS CDOs are pricing in the Libor plus 47.5 to 50 basis points range. Minimum senior debt widening reflects continued conduit demand, but lower tranches have not been as insulated thus far.
Currently, the CDO-of-CDO bid is not as strong as in the past, with very few of these deals visibly in ramp up mode, according to one dealer. "There's only a handful of CDO-of-CDO shops out there and they want bargains," added the source. Triple-B bonds have gapped-out approximately 50 basis points (L+220-280), and double-Bs (L+650-725) even further, according to UBS Warburg.
Since spreads in the rated debt tranches have been all across the board, equity investors are finding it very difficult to evaluate assumptions on new deals as the price discovery process drags on. Moreover, it is particularly difficult for the non-benchmark issuers to project returns, because their levels vary more dramatically from the Mass Mutuals and TCWs of the world.
In a recent research report from UBS, Laurie Goodman and Douglas Lucas point out that the impact of the Sept. 11 attacks will linger in the CDO market. For example, S&P recently released a list of 30 CDOs that have high airline or lodging industry concentrations, all of which have been placed on a list for further study. In the next few weeks, the ratings on these deals will be reaffirmed, reduced or placed on watch for possible downgrade.
On a positive note, wider spreads in high yield and investment-grade corporate markets, as well as in the ABS market, have actually strengthened upcoming deals by adding cushion, versus outstanding deals.
Warburg asks whether or not these are the worst of times for CDOs. So far in 2001 Moody's downgraded 98 tranches in 37 CDOs. Additionally, Moody's is also holding 108 tranches in 46 CDOs on watch for downgrade. This is the fastest CDO downgrade pace since the fourth quarter of 1998, when emerging market CDOs were hit with a wave of credit actions.
Through their examination of past CDOs, UBS finds that the 1999 cohort is following past cohorts with respect to par deterioration. "With respect to subordinate O/C ratios, it seems that the 1999 cohort is threading its way betwixt and between the 1997 and 1998 cohort," Warburg research team writes.
The prospect of the 1999 CDO cohort following the previous 1998 and 1997 is alarming, considering the average 1998 CBO is violating its subordinate O/C test while the average 1997 CBO is violating both its subordinate and senior O/C tests.
So why is UBS optimistic for the future? The past year has seen both structural and risk-return improvements, the firm said, highlighting the following:
*average credit quality of a CDO portfolio will exceed that of the HY universe as a whole;
*debt tranches on CDOs benefit from structural enhancements which the market insisted on over recent years;
*closer investor scrutiny on previous deals causes managers to be penalized more heavily in the future if they bring a deal at the wrong time;
*high yield market risk-return is generally quite favorable during periods of high default rates and wide spreads;
*issuance will be down, and deals will naturally receive closer scrutiny; spreads will be wider, particularly for mezzanine tranches.
