The summer lull descended upon the market as CDO issuance reached paltry levels last week. While arbitrage and structured product CDOs make up the bulk of the current pipeline, market talk focused on high yield loan-back vehicles and wider-than-expected spreads.
As July opened, CDO issuance for the U.S. market hit approximately $22.2 billion, according to JP Morgan Securities, down from the $28.7 billion tallied at the same point in time last year. Issuance for the start of the month was extremely slim, just $350 million, thanks entirely to the pricing of Goldman Sachs-led NYLIM Flatiron CLO 2003-1. An arbitrage deal managed by New York Life, sources report the top tranche priced at 55 basis points over three-month Libor. The July 4 holiday obviously impacted the market; however, take heart of the fact that July 2002 cashed out at $2.08 billion, according to JPMorgan figures.
Structured product CDOs have made up half of the volume this year and a noticeable spike in high yield loan-backed issuance has taken place. This year, high yield loan deals have comprised 42% of issuance whereas in 2002 they comprised 20% for the year.
But while high yield loan and structured finance backed CDOs have become the market's darling, UBS Warburg researchers have given a poor prognosis to synthetic and investment grade (IG) CDOs, at least in the short term; the arbitrage in these deals has been "killed" as CDO tranche spreads on IG credits tightened less than single-name credit default swaps, they said. UBS researchers pointed out the TRACERS index of 100 CDS has not been above 90 basis points since April, and dipped to under 70 by last month.
Unlike other sectors, CDOs have not experienced the spread tightening seen with ABS this year. However, Deutsche Bank's research department believes the market is poised to begin catching up with ABS products, pointing to the improving credit story in the leverage-loan sector as a place to pick up yield.
The firm counts itself among the optimistic in viewing the end of the sour rains that have poured over the U.S. high yield bond market, noting the high-yield corporate default rate declined for the fifth straight month, according to Fitch Ratings. Cash-flow CDOs are indirectly benefiting, Deutsche Bank pointed out, as higher recoveries on defaulted collateral help reduce par erosion. Investors should not be overly jubilant in expecting a comeback of high yield bond-backed CDOs anytime soon, however. Downgrades continue to be issued by various rating agencies on late 1990 vintage bond deals.
On that note, three high-yield bond-backed CDOs currently languish in the pipeline: Robeco CDO V, a $410 million CDO managed by Weiss Peck & Greer; Liberty Square III, a $250 million CDO managed by Wellington Asset Management; and Mount Mitchell CDO II, a $300 million vehicle managed by White Ridge Investment Advisors.