Insufficient liquidity in the CDO market: the tail wagging the high-yield dog

By Paul A. Harris

St. Louis, May 12 - Trades involving credit default instruments meant to hedge the risk of owning bonds - so-called "tranche trades" - began to amplify the selling pressure in an already distressed high-yield market earlier this week, according to hedge fund manager.

"These CDO [collateralized debt obligation] trades are correlation trades," the manager told Prospect News Thursday, speaking on background.

"Some of them involve a very low level of risk," the manager added, explaining that a low-risk CDO tranche - or a comparable trade using credit default swaps - might contain a basket of 100 credits.

Investors can adjust the level of risk by specifying how exposed they are to defaults on the underlying credits, depending upon the specifics of the particular tranche.

Based on hedging models, investors are able to take positions, both long and short, in various tranches to correlate the risk-return dynamics of the underlying credits in their portfolios.

Ford and GM: the perfect storm

The manager went on to say that volatility rocking the high-yield market at present is a function of the massive volume of securities pouring in because of Standard & Poor's downgrades of Ford Motor Co. and General Motors Corp. debt coupled with the immaturity - and therefore the illiquidity - of the CDO market.

"When you have that much paper pouring onto the market there is just not enough liquidity in any of these index products," the source said. "And all of the correlations went out of whack.

"One big player was covering a short, supposedly, and just could not transact enough, and it threw everything off."

"People were buying these instruments, trying to protect against systemic risk. And Ford and GM were specific events that in and of themselves were so large that they became the tail that wagged the dog."

Illiquidity and transparency

The manager went on to say that the CDO market's relative lack of depth, coupled with its relative immaturity, quickly drove up players' anxiety levels earlier this week.

"There is a lot fear in the market that somebody is going to go out, which magnifies the risk in these illiquid instruments," the hedge fund money manager said.

"With a bond, at least you can look on a screen and see where it is trading. But you don't know what people have behind the scenes in all of these CDOs. There is a lot of junk tucked away in there.

"And to the extent that people don't have transparency they assume the worst and they vote with their feet, which increases pricing on all products.

"Until there is more confidence in the market I suspect that we are going to stay under pressure."

Shortly after this conversation took place other market sources confirmed that trailing a hopeful Thursday start, the high-yield market did in fact remain under selling pressure throughout the session and closed lower on the day.

Protracting the pain

The hedge fund money manager went on to characterize the high-yield market as presently "distressed," by the massive amount of fallen angel paper from Ford and GM. And, the source added, it may take some time for the junk market's digestive system to adjust.

"We have two-year paper in General Motors," said the source. "It's yielding 10%.

"Any other two-year bond that we might consider buying has to be compared to that GM bond. "For example, assume there is a two-year bond yielding 7%. You have to ask yourself 'Am I better off buying more GM or the other bond?' If you are going to buy the alternative two-year bond, 7% is not enough, if GM is 10%. So the issuer of the alternate two-year bond has to go to 8½%, let's say.

"The result is that you have a new benchmark junk bond that is too big for the market to absorb.

"Ford and GM, together, including their financing units, are so big that the traditional high-yield market has had a hard time digesting them. And as a result they have set a new benchmark against which a lot of other credits are being measured.

"And therefore those other credits are being marked down."

Specter of redemptions

As if the above-described forces were not enough, the hedge fund money manager told Prospect News that institutional investors now have to reckon with the specter of redemptions.

"All of this uncertainty is causing redemptions, so we don't know what our capital is," the source said.

"You may have half a billion dollars but you don't know whether or not you will lose a couple of hundred million over the coming months, if things get really bad. Why put on more General Motors when you may have to sell it into a distressed market? That will just make it that much worse for my remaining investors."

Hence, said the manager, not only is the market not deep enough today, but everybody in the market is afraid that their assets are going to shrink, and that it may be even less deep later on.

"People are selling now with the idea that they will buy it back when it's cheaper. Even if you have to pay up for it later, at least you will know what your capital base is."

Clarity on the horizon?

Characterizing the present high-yield market as a "sick market," the investor said that a cure may be on the horizon.

"Most funds have a quarterly redemption window," the manager said. "And I suspect that if people are going to redeem they will have put in their redemption notices by the end of this month.

"So by that time people should have a better sense of what their capital base is going to be, which should make them a little more aggressive.

"But if things stay this bad from June through September, there are going to be a lot of investors who will be sad because they didn't redeem in June.

"People may buy more," the manager said, "but they are not going to go crazy."

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