BoA: single-tranche CDOs compensate well for their risks

The spread pick-up is currently most pronounced for double-A, single-A and triple-B tranched product, according to research by Lang Gibson, New York-based director of structured credit products research at Bank of America, and his colleague Zu-Shan Lee. For example, during the past 12 months, the spread pick-up of single-A rated single-tranche CDOs over similarly-rated commercial mortgage-backed securities has grown from 154% to 318%.

Gibson and Lee point to relative illiquidity and lack of pricing transparency, and recent poor performance by CDOs, as among the major risks responsible for the high compensation available to investors in single-tranche deals.

However, Gibson and Lee contend that each of these factors is now being countered by changes in the market. Investors concerned about illiquidity can chose tranched index products. Similarly, those investors that are concerned about transparency can use the latest generation of forward-looking credit portfolio models to get a more objective sense of the risk-return profile. Finally, single-tranche CDO rating and price performance have rallied since October 2002, according to BoA.

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