CDO notes have generally been a better investment than corporate bond swaps over the past three years, Wachovia Securities analysts said in a research report issued last week. For the study, analysts used a performance analysis based on new-issue spreads over the time period. While mezzanine CDO investors have enjoyed quite a bit of yield amid the recently stable credit environment, analysts are recommending an up-in-credit and asset diversification strategy going forward.
"I think we are finding pretty decent value across the board," said Steven Todd, an analyst at Wachovia. "Even for corporates, we have found that these have had better performance, but for relative value across sectors, I think we'd be most comfortable advising investors to look at CLOs as opposed to ABS CDOs." Interestingly, the analysts also found less correlation than they expected between the ABS CDO and CLO sectors, as well as between corporate bonds, equity and CDOs.
As the credit default swap market continues to grow, particularly swaps referencing CDOs, so will the need to manage CDO mark-to-market risk or fluctuating market values, Wachovia points out. And because there is no comprehensive system in place to track secondary market pricing, the analysts chose to track pricing, in this case, using new issue data. To put it broadly, the analysis assumed notes were purchased at par, and then marked the position based on the value of early redemption one year later; risk was factored in using ratings transition and recovery data from Moody's Investors Service.
Because of the low-risk environment over the past three years, Wachovia initially measured only risk and return. The resulting Sharpe ratios, the result of subtracting the return of a risk-free asset (in this case three-month Libor) from the realized or expected return on a risky asset, favored subordinate leveraged loan CLO tranches. The triple-B CLO tranche, on average, produced a 4.81 ratio over the three-year time period, while the triple-B tranche of a mezzanine ABS CDO only produced a 0.87 ratio. Meanwhile, the triple-B risk on the Lehman Brothers U.S. Corporate Index produced a 0.16 Sharpe ratio of a three-year time period, although the performance improved with hedging for interest rate risk.
"I think this is a new approach to gauging performance," Todd said. "I don't think our competitors have looked at it this way." Wachovia analysts are preparing a subsequent report that should detail how to use this methodology over an entire credit cycle, which would provide a more realistic measure of risk compared to looking at historical data over a benign credit period.
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