Some analysts are becoming worried that corporate credit deterioration will soon provoke some real damage in the CDO market, a trend not seen yet. According to sister publication, Bondweek, several CDO tranches are severely stressed, according to Gus Harris, managing director with Moody's Investors Service, who predicts that some will likely default by their maturity date: which would be a first. "We are at the peak of feeling the pain of the bad vintages of 1997 and 1998," says Anthony Thompson, head of CDO research with Deutsche Bank. The newer CDO vintages for 1999 and 2000 will perform much better, he adds.
Thompson says the current credit deterioration is only temporary. Harris agrees to a degree, writing in a research report issued last week, he says the 1997-1998 vintage was characterized by a higher cost of the underlying assets, contrasting with the 1999 and 2000 deals whose collateral was cheap, providing managers with more cushion for downgrades. "We are paying the price today as these credits go through their seasonal cycle," notes Thompson.
Harris was traveling last. Jeffrey Tolk, analyst with Moody's, declined comment on which transactions or which tranches are the most likely to default. Jeremy Gluck, another Moody's analyst, says that during the first quarter, the agency downgraded 40 CDO tranches within 14 transactions. During the same period, Standard & Poor's placed on CreditWatch 12 tranches and downgraded the ratings of 10 tranches.
Harris also argues that the lack of defaults to date should not fool anyone: "CDO investors are vulnerable to default risk," he warns. He notes that there should be no surprise if CDO notes (not the collateral) have not defaulted. A CDO note initially rated below A2 can avoid the default through a legal mechanism called "PIK," he explains. In case a CDO fails to pay a coupon, it can bypass the default by simply issuing additional notes, he says.
Buysiders aren't panicking, but they are starting to cut bad vintage exposure. "I certainly don't see any panic selling in the secondary market. But I do see some people trying to reduce their exposure in the 1997-1998 vintages," says Andrew Dickey, portfolio manager with Mass Mutual/ David L Babson, a Springfield, Mass.-based insurance company.