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.