Introducing the BAS CDO ROE barometers.

• Author: Gibson, Lang
• Position: Collateralized debt obligations - Return on equity

When examining opportunities in the CDO markets, the high existing arbitrage opportunities must be viewed jointly with expectations of some defaults. Therefore, although arbitrage spreads are useful exante indicators of issuance and investor demand, more meaningful is the return on equity (ROE) for the equity investors in a CDO. ROE will account for not only asset yields and liability costs, but also expected defaults, expenses and fees, and leverage. In this article, we introduce our CDO ROE barometers, which quantify the attractiveness of issuing and investing in CDOs at a given time. As generic barometers, they do not represent the economics of specific deals or sets of deals. Rather, the barometers are gauges of the economic incentives for investing in CDOs backed by different types of collateral (further explanation is provided in the methodology sections for each barometer). Our barometers represent the hypothetical equity returns of four generic CDOs, each backed by different types of collateral: HY bonds, HY loans, IG corporate bonds, and structured products of various types.

1. TRACKING ARBITRAGE OPPORTUNITIES

   The visibility of CDOs has increased considerably over the past few years. Rated CDO notes are now found in the portfolio of virtually any fixed income manager buying structured product. CDO equity buyers, however, are a smaller crowd. As the economy has slowed, this market has become more saturated and it has become more difficult to find these buyers. Indeed, the current economic environment has created unusual circumstances within which to examine the CDO markets. The recent tragedies have disrupted the equity and debt markets and have had some muted effects on CDO pricing. In our opinion, investor perceptions of CDO equity closely correspond to those of the stock market, especially in times of uncertainty. For example, increased investor caution has always correlated with a higher entry threshold for both markets, as investors wait to buy until the economy improves. Of course, at this point the unhealthy economic environment has already been discounted in equity markets, whether in stocks or CDOs. The challenge for investors is to build an equity portfolio before lagging indicators of economic performance show conditions have already improved.

   Arbitrage spreads--the main driver behind CDO issuance and equity performance--are at historically high levels due to the combined effects of a substantial spread widening in the underlying collateral markets and the relative stability of CDO liability spreads. Asset spreads have recently begun to level out, but remain nonetheless at historic wides, particularly against swaps. The three major drivers of this spread widening have been an acceleration in liquidity, an increase in credit risks and technically tight swap spreads. However, underlying collateral defaults are at their highest levels since the 1990-91 recession period, due to such interrelated factors as the recent economic downturn, the weak state of the corporate bond markets, and decreased investor confidence, all of which have been exacerbated by the events of Sept. 11.

   When examining opportunities in the CDO markets, the high existing arbitrage opportunities must be viewed jointly with expectations of some defaults. Therefore, although arbitrage spreads are useful ex-ante indicators of issuance and investor demand, more meaningful is the return on equity (ROE) for the equity investors in a CDO. ROE will account for not only asset yields and liability costs, but also expected defaults, expenses and fees, and leverage. In this article, we introduce our CDO ROE barometers, which quantify the attractiveness of issuing and investing in CDOs at a given time. As generic barometers, they do not represent the economics of specific deals or sets of deals. Rather, the barometers are gauges of the economic incentives for investing in CDOs backed by different types of collateral (further explanation is provided in the methodology sections for each barometer). Our barometers (Exhibit 1) represent the hypothetical equity returns of four generic CDOs, each backed by different types of collateral: HY bonds, HY loans, IG corporate bonds, and structured products of various types (henceforth we will refer to this deal type as "multi-sector"). These barometers are updated weekly in our Structured Credit Strategy Weekly.

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2. RELATIVE VALUE OPPORTUNITY

   Exhibit 2 summarizes the various assumptions and relative value opportunities specific to each deal type for base case (the empirical average adjusted for a degree of manager outperformance) and stressed case default scenarios. In the current high-default environment, most investors' assumptions will fall somewhere between the base case and stressed case to account for high front-loaded defaults. Base case assumptions range from a 0.25% constant annual default rate (CADR) for IG corporates and multi-sector deals to a 2.0% CADR for HY bonds, while the stressed case scenarios assume a range between 1.0% CADR for multi-sector collateral and 4.0% CADR for HY bonds. Under base case assumptions, the barometers (readings are as of November 2, 2001) span from 38.8% for HY bond deals to 23.0% for multi-sector CDOs, and under the stressed case scenarios, the barometers range from 28.8% for HY bond deals to 15.5% for multi-sector CDOs. HY loan transactions, whose issuance has recently accelerated after a relative lull during the middle of the year, offer the second most attractive returns, with a base case IRR of 33.6% and a stressed case IRR of 29.1%. Multisector and IG corporate deals offer similar rates of return, with base cases of 23.0% and 27.6%, and stressed cases of 15.5% and 16.4%, respectively.

   The primary driver behind the high ROEs implied by our barometers is the spread widening environment, which, in turn, has been driven by the following four factors:

   * Liquidity risk. We are currently experiencing a spread contagion effect similar to what occurred in the fall of 1998 following the LTCM crisis. Much of the spread widening has occurred because of the premium required to compensate for a heightened probability of poor execution in the event of a sale and wider bid-ask spreads.

   * Technically tight swap spreads. Ten-year swap spreads would be almost double their recent 60- to 70-bp trading range if not for three technical factors: convexity buying by mortgage bankers in the face of a rallying Treasury market producing prepayment pressure, heavier-than-anticipated Treasury supply, and exceptional carry. So long as these technical aberrations remain unchanged, we will continue to see historically attractive arbitrage opportunities...