Bid/offer spreads on collateralized debt obligations in the secondary market have narrowed to as close as 25 basis points for some tranches, according to CDO traders, who say the spreads are getting tighter as liquidity improves. The most liquid senior, triple-A tranches, such as those backed by high-yield collateral, often trade on a quarter-point spread, while CDOs backed by structured securities still trade wider. This is down from as much as up to 100 basis points a year ago. They attribute the tighter trading spreads to Abbey National's liquidation of more than $5 billion in CDO paper earlier this year, which forced dealers to analyze bonds that were put out for the bid, as well as improved transparency.
To be sure, CDOs are still illiquid compared to other parts of the bond market. Bid/offer spreads on current coupon mortgage-backeds can be as tight as one basis point, while the gap tends to be five basis points on liquid credit default swaps.
And, not all parts of the CDO capital structure are even that liquid. For mezzanine and subordinate tranches, traders say bid/offer spreads on CDO liabilities can be as much as 200 basis points apart. Brain Wargon, senior v.p. and head of CDO trading at Lehman Brothers, acknowledges this is a wide gap but says investors are compensated generously with yield in the CDO market, making up for its illiquidity relative to other fixed-income instruments. He was speaking as part of a trader roundtable at the Bond Market Association's CDO conference in New York last week.