CDO ratings hurt by rates risk, says Fitch

The market preoccupation with default rates negatively affecting collateralised debt obligations (CDOs) ignores the equal risk of interest rate risk embedded in high-yield cashflow instruments, especially for deals completed between 1997 and 1999, according to rating agency Fitch.

Typically, investors prefer floating-rate interest payments from CDOs. But in many cases the underlying CDO assets have fixed interest rate payments. For those CDOs that purchase fixed-rate assets, the subsequent interest rate risk is hedged using derivatives such as interest rate swaps.

Authors Brian Gordon and John Schiavetta of a Fitch report Impact of Interest rate swaps in Cash Flow CDOs said the effectiveness of the interest rate hedging strategy can “have a significant influence on the amount of excess spread available as credit enhancement to these transactions”. The authors also warned of a 'perfect storm' scenario, when high default rates combine with low interest rates to cause CDOs to become significantly over-hedged and out-of-the-money on their swaps positions at the same time.

“This combination of events has exacerbated the downgrades of a number of these transactions beyond what would be dictated by high underlying default rates alone,” said Gordon.