Return rates on investments in the first-loss pieces of certain collateralized debt obligations are creeping higher and investors should consider picking up these riskiest of CDO assets, according to analysts at Merrill Lynch. The firm notes return rates on equity pieces have risen recently to 13-15% for leveraged loan and mezzanine structured finance CDOs in recent months.
Although the recommendation is somewhat counterintuitive given the increase in risk aversion, Merrill's analysts say now is the best time for investors to buy CDO equity, particularly from the new issue market. That's because historically the best time to move into the asset class has been when underlying assets weaken due to technical factors, such as in the recent broader market sell-off following the General Motors and Ford Motor Co. downgrades. The analysts cite the fourth quarter of 2001 and the same period in 2002 as times when credit spreads widened on supply/demand imbalances that presented an opportunity for investors to buck the trend and pick up first-loss pieces of CDOs. "Via CDO equity, investors are able to lock in this technically driven wider excess spread for the long term," analysts Lang Gibson and Katie Lynch wrote in a note to investors last week.