Investors Warned On CDO Prepay Risk

Investor flows into senior collateralized debt obligation classes are causing bonds to increasingly trade at a premium, but sell-side researchers say investors don't appear to be factoring in the escalating risk of prepayments.

  • 10 Sep 2004
Email a colleague
Request a PDF

Investor flows into senior collateralized debt obligation classes are causing bonds to increasingly trade at a premium, but sell-side researchers say investors don't appear to be factoring in the escalating risk of prepayments. The premium implies investors will be able to reap healthy yields but prepayment may shut off these yields sooner than investors expect.

The dramatic tightening in liability spreads, specifically in CDOs backed by bank debt as flocks of investors head to the asset class, is making this an issue worth noting now, they said. "A lot of deals were issued at [LIBOR plus] 50-55 basis points a couple years ago and now spreads are 35bps, so many deals are trading at a premium," explained one researcher, adding, "if the collateral prepays, you're not earning yield fast enough." Many clean, seasoned classes issued in recent years are trading at premiums though market participants were unable to quantify what proportion of outstanding classes is currently above par.

The emergence of prepay risk in the CDO market, while certainly worthy of careful analysis, is also something of a badge of honor for the industry given it is due to positive performance.

"For some of the tranches, prepay risk has become a bigger concern than default risk," said Douglas Lucas, director in CDO research at UBS in New York. For example, he pointed to ML CLO XV Pilgrim America 1998-2, a CDO backed mainly by loans but with 20% of its assets in high-yield bonds. Lucas said the weighted-average life of the A-2 class can range from 0.75 years to 2.25 years depending on the prepay rate, which could have a negative impact on yields if the investor holding the bond purchased it at 105. "Investors haven't been evaluating [prepay rates] maybe as much as they should," he stated.

All that being said, CDO professionals are quick to point out the emergence of prepay risk is another sign the CDO market is maturing and is a positive one. The trend is being fueled by conditions in the underlying collateral markets, including asset-backed securities and bank loans. Improving credit conditions are resulting in the underlyings being prepaid or called, which has trickled down to the structured credit vehicles. 

  • 10 Sep 2004

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 Citi 317,691.74 1201 8.90%
2 JPMorgan 291,227.96 1326 8.16%
3 Bank of America Merrill Lynch 285,088.11 991 7.99%
4 Goldman Sachs 217,749.25 714 6.10%
5 Barclays 209,291.80 811 5.87%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 HSBC 32,320.82 147 6.67%
2 Deutsche Bank 32,259.50 104 6.66%
3 Bank of America Merrill Lynch 28,890.43 85 5.96%
4 BNP Paribas 25,663.29 144 5.30%
5 Credit Agricole CIB 22,617.86 130 4.67%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 JPMorgan 18,160.85 71 9.15%
2 Morgan Stanley 15,215.44 76 7.67%
3 UBS 14,195.29 55 7.15%
4 Citi 14,014.57 86 7.06%
5 Goldman Sachs 12,113.98 67 6.10%