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When examining opportunities in the CDO markets, the high existing arbitrage opportunities must be viewed jointly with expectations of some defaults. Therefore, although arbitrage spreads are useful exante indicators of issuance and investor demand, more meaningful is the return on equity (ROE) for the equity investors in a CDO. ROE will account for not only asset yields and liability costs, but also expected defaults, expenses and fees, and leverage. In this article, we introduce our CDO ROE barometers, which quantify the attractiveness of issuing and investing in CDOs at a given time. As generic barometers, they do not represent the economics of specific deals or sets of deals. Rather, the barometers are gauges of the economic incentives for investing in CDOs backed by different types of collateral (further explanation is provided in the methodology sections for each barometer). Our barometers represent the hypothetical equity returns of four generic CDOs, each backed by different types of collateral: HY bonds, HY loans, IG corporate bonds, and structured products of various types.
I. TRACKING ARBITRAGE OPPORTUNITIES
The visibility of CDOs has increased considerably over the past few years. Rated CDO notes are now found in the portfolio of virtually any fixed income manager buying structured product. CDO equity buyers, however, are a smaller crowd. As the economy has slowed, this market has become more saturated and it has become more difficult to find these buyers. Indeed, the current economic environment has created unusual circumstances within which to examine the CDO markets. The recent tragedies have disrupted the equity and debt markets and have had some muted effects on CDO pricing. In our opinion, investor perceptions of CDO equity closely correspond to those of the stock market, especially in times of uncertainty. For example, increased investor caution has always correlated with a higher entry threshold for both markets, as investors wait to buy until the economy improves. Of course, at this point the unhealthy economic environment has already been discounted in equity markets, whether in stocks or CDOs. The challenge for investors is to build an equity portfolio before lagging indicators of economic performance show conditions have already improved.
Arbitrage spreads-the main driver behind CDO issuance and equity performance-are at historically high levels due to the combined...