Though some argue the "no brainer" buys in the relatively new secondary CDO market disappeared six months ago, structural features of securitization have, in some cases, created a timing/rating arbitrage, whereby savvy investors can pick up downgraded mezzanine tranches of CDOs just before the notes start paying down.

For banged-up deals especially, such de-leveraging can warrant positive rating action of previously downgraded notes, even when the underlying portfolio has deteriorated further, though, according to sources, investors have typically priced this in well before the rating action. Still, most positive CDO rating actions over the past several months have been independent of or, in many cases, a result of portfolio deterioration, as the triggers embedded in the deals will often cause the top most notes to trap cash and/or pay down until the stress tests are met.

Of course, in this situation, you wouldn't want to be at the bottom of the capital structure.

According to a source at a secondary trading shop, regardless of any potential ratings benefit, the structural protections built into CDOs may create good buys for downgraded tranches, especially in an improving credit environment.

"It is definitely an opportunity, but it can be a timing game," the trader said. "If you're in the [amortizing] mezzanine piece, you're betting that it's going to get paid out before the defaults hit it."

Last week, Moody's Investors Service placed classes from two CDOs on watch for possible upgrade, one attributable to the paydown of a senior class, and the other due to rapid amortization.

Moody's placed the two senior classes of Eurostar CDO I on watch for upgrade. Both classes were originally rated Aaa,' and since lowered to Aa3'. For this 2000 vintage CDO backed by a mix of European and U.S. bonds, Moody's writes, "despite the deal's continued violation of all its over-collateralization tests and certain portfolio profile tests, the watchlist action is the result of the continued beneficial amortization of the above notes, which is expected to continue going forward."

Moody's also placed an A2' rated B class from CypressTree Investment Partners I on watch for upgrade. CypressTree is a 1997 high yield loan cash flow deal. The B class was originally rated Aa3.' The watchlist action is the result of senior notes having completely paid out.

Like CypressTree, other late 1990 vintage deals are de-leveraging, either through natural course, or triggered repayment.

A further stretch, perhaps, a CDO analyst noted that once the reinvestment period ends, a collateral manager is unable to game the stress tests through par-building trades or likewise.

If the integrity or priority of the collateral manager is in question, the end of the reinvestment period may also be an opportunity, as structural protections for the senior debt classes could kick in.

Credit watch

positive

As mentioned above, many researchers are bullish on corporate credit going into 2004.

"The four critical factors driving the high yield market (the macro environment, credit fundamentals, technicals and valuation) all point to a positive outlook for the coming year," write researchers from Banc of America Securities in the January Leveraged Finance Market Edge.

An improving credit environment has and will continue to benefit corporate-backed CDOs, especially on the loan side, said Gus Harris, a managing director in the CDO group at Moody's. For loans, a significant amount of amortization, mostly related to refinancing, has flushed cash into the deals, which some managers are using to pay down the notes.

Bond-backed CDOs are also benefiting from improved credit, though the low interest rate environment continues to put pressure on certain deals that hedged interest rate risk with swaps (CDO liabilities are typically floating rate). Essentially, if there's been deterioration, the asset pool may no longer match the swap notional entered into at new issue. While this has resulted in a net outflow of cash, it also exposes these deals to incremental upside if interest rates rise.

Conditions right for CLO's ?

As for the new issue market, the landscape for CLOs may be improving, following a record near-$30 billion fourth quarter of high yield loan issuance.

While loan spreads have been at historic tights, the added volume may help widen the sector, noted UBS in its most recent CDO Insight.

Others argue that renewed demand will continue to counter the added volume.

UBS said that in the fourth quarter deals adapted to the tightening collateral markets through structural changes, such as tranching out the triple-A class, or structuring in a double-A class between the single-A and the seniors - all attempts to "get the most out of ever-decreasing loan spreads for CDO equity."

Either way, spreads on the liability side of corporate CDOs have come in several basis points over the last few months.

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