Some senior tranches of fixed-rate collateralized debt obligations are trading at significant premiums on the secondary market. Some sell-side analysts say the premiums are caused by the low interest rate environment, and note that the situation is rare because secondary CDO notes rarely trade above par.
Joshua Anderson, Merrill Lynch's CDO analyst, says that some triple- and double-A rated notes of high-yield-backed CDOs from the 1998 or 1999 vintages were trading in the $102-103 range late last week. With interest rates at an all-time low, investors are willing to pay a premium for those bonds that carry a 7-8% coupon, he says. Some of those bonds are wrapped, which is an additional factor leading to the premium. Finally, the bonds are "clean" notes that have not suffered a lot of credit deterioration, although the transaction itself could be distressed, he says.
Anderson says fixed-rate seasoned CDOs could, in theory, trade even higher due to their high coupons. One reason premiums have not edged much higher is because there is no "standardized" method to analyze convexity risk, he says. As a result, investors make conservative assumptions based on various factors such as reinvestment period, over-collateralization triggers and quality of the manager.
Another analyst says that most CDOs are floating notes, and that the premium attached to fixed-rate CDO notes is due to their relative limited supply. Almost all CDO floating-rate notes trade at a discount, he says, and the range varies widely. As a comparison, triple-A rated CDOs floating-rate notes usually trade in the $90-95 range, traders say.