The third quarter report card for U.S. CDOs released last week by Standard & Poor's, showed some expected strengths - located in the high-yield corporate bond and loan sectors - as well as the usual weaknesses, such as later vintage MH ABS-backed securities. And judging by the make-up of deals currently on either negative or positive review by the rating agency, this quarter's trends are likely to continue into yearend.
S&P upgraded 22 CDO classes and downgraded 18 in the third quarter. The number of upgrades, all but three of which were on cashflow CDOs, declined by a little more than a third from the previous quarter's 36 upgrades. The rating agency's ratio of CDO upgrades to downgrades for the quarter was 1.22 - making it only the third time in which the upgrade-to-downgrade ratio was greater than one, yet still lower than the second quarter's 2.11 ratio.
Not surprisingly, for the first time, deals within the U.S. auto and airline sectors prompted more downgrades to synthetic CDO transactions than upgrades, totaling eight and three, respectively.
Some 36% of CDO upgrades in the third quarter came from the high-yield CBO sector, where the low interest rate environment has fueled a deluge of early payoffs. According to a recent S&P report, for more than 107 cashflow CDOs currently amortizing, at least one security within the underlying collateral will experience an option call before the end of 2006 (see ASR 8/22/05). Sixteen high-yield CBOs were upgraded in the second quarter, amounting to almost half of S&P's CDO upgrades during that time period.
Although structured-finance CDOs accounted for all of the cashflow CDO downgrades in the third quarter, the total number of downgrades within the asset class throughout the quarter was the lowest yet this year. Eleven cashflow CDO tranches were lowered, along with seven classes of synthetic CDOs.
The third quarter was the sixth in a row that structured finance CDO downgrades reached double-digits, and, the sixth quarter in a row that these CDOs have dominated the downgrades. The same old culprits - such as manufactured housing-backed securities - take the blame for most of the downgrade activity, all but two of which were initiated on already-downgraded tranches. For example, five structured finance CDOs downgraded had a greater than 10% exposure to manufactured housing, and of those deals with more than 10% exposure, the manufactured housing securities constitute anywhere between 13% to more than 21% of underlying collateral.
Adding something new to the relatively familiar performance trends of the structured finance CDO - for the first time, a 2003 vintage deal was downgraded by S&P for negative credit performance. The 2003-vintage deal was the only non-2000 through 2002 vintage to receive a downgrade in the third quarter.
High-yield CLOs enjoyed the eleventh consecutive quarter without a single senior tranche downgrade, and the sector accounted for four of the upgrades. But with the tight spread atmosphere these deals are experiencing, more than a few have violated their weighted average spread requirements, according to S&P (see ASR 10/17/05). Spreads for "BB" and "BB-" rated institutional loans tightened to less than 200 basis points over Libor in July from more than 400 basis points over Libor in April of 2003.
As of Sept. 30, 46 U.S. CDOs were on the rating agency's credit watch negative list,
and 31 were on ratings watch positive. The majority of the transactions waiting for upgrades were high-yield CBOs, while structured finance CDOs stood at the other end of the spectrum.
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