After enjoying smooth sailing for a long time, cash multi-sector collateralized debt obligations--also called asset-backed CDOs or multi-sector CDOs--are expected to find the going rough in the new year. The sector used to be considered more default-proof than corporate-backed CDOs, but downgrades have slowly made their way into the sector and are causing investors to take notice.
Investors say caution is the watchword. "Absolutely, we are becoming more cautious on ABS CDOs," says a CDO investor who manages a portfolio of $4 billion CDOs. "People used to like this sector because there were no downgrades. Now we're starting to see downgrades and I think there will be more." This investor adds that besides credit deterioration, one main concern is interest rate risk. As the ABS collateral amortizes, it needs to be reinvested periodically. But, with the yield curve as flat as it is, collateral managers cannot reinvest the proceeds at a decent yield. "We don't think there is adequate compensation for this risk," notes the investor.
In September, Fitch Ratings downgraded Dash I, the first time it lowered ratings on a structured finance CDO. Since then, the agency has downgraded two others, including one last week. "We believe that further downgrades in some of the earlier structured finance CDOs are likely," says Dan Castro, head of ABS research at Merrill Lynch, adding, "The last few months have not been kind to structured finance CDOs."
A sell-side analyst says that part of the problem is that multi-sector CDO spreads trade in tandem with the mezzanine structured product notes backing them. With ABS spreads widening since last summer, ABS CDOs have seen their spreads come out as well.
As an example, he says, triple-B rated ABS CDO notes were trading last week at 325 basis points over LIBOR versus a 250 basis point spread two months ago. No information is available on secondary pieces, but traders say the widening is even more significant there, with spreads widening in some cases to up to 10%.
Castro notes that investors have to contend with credit risks associated with some distressed ABS asset classes backing those deals such as Enhanced Equipment Trust Certificates, 12B-1 fees, franchise loans and manufactured housing. The Conseco Finance headline risk has played a role too, says an investor, although the market "saw the blow-up coming months before" and has slowly priced it in. Nevertheless, exposure of structured finance CDOs to ABS bonds issued by Conseco Finance is not insignificant. A study by Fitch Ratings shows that out of the 58 structured finance deals it rates, 35 have exposure to the Conseco Finance collateral with an average exposure per deal of 5.88%. Katie Lynch, an analyst at Fitch, says newer deals are avoiding those sectors by using "plain vanilla" assets for backing, such as credit cards, higher quality triple-A or double-A pieces of manufactured housing paper or auto ABS.