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Bear Stearns: Time To Change CDO Valuations

31 Jul 2003

BondWeek is the leading news publication for fixed-income professionals, covering new deals, structures, asset-backed securities, industry and market activity.

Investors in collateralized debt obligations should rethink some of their underlying assumptions given improving credit fundamentals and low interest rates, according to Gyan Sinha, head of CDO research at Bear Stearns. Sinha argues bondholders of high-yield CDOs traditionally have incorporated a 0% call rate into their analysis. But, with more and more high-yield bonds now trading at a premium and issuers exercising their call options, the call rates have been rising and will continue to do so. Call rates on a high-yield index topped 8% in May, compared to 4% for the same period one year ago. And, this has an indirect impact on the CDOs they are included in. "When you assume a 0% or low call rate, you get a bond that is longer under those assumptions than it really is," he adds. Sinha says it is particularly important for investors to rethink their call rate assumptions now because the primary market for high-yield CDOs has essentially shut down, forcing them to find inefficiencies in the secondary market.

One veteran structured finance investor says the theory makes sense, noting that in general investors tend to stick to dated modeling techniques even as underlying characteristics evolve.

For example, Sinha says if an investor assumes a 0% call rate, and it turns out to be much higher, that bond will amortize quicker than expected and force a reinvestment at current rates. But, by assuming higher call rates--and thus shorter bonds--investors can calculate a more accurate maturity and enhance the yield on a CDO, according to Sinha.

31 Jul 2003