CDO ratings hurt by rates risk, says 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.