The recent rally in CLOs and in credit more broadly has supported the burgeoning liquidity in the CDO secondary market, with BWIC activity accounting for around US$1.6bn in June so far. However, the threat of mass downgrades is still weighing on the sector.

"Certainly we've seen increased liquidity in the CDO marketplace over the past two months, albeit last week activity slowed down a bit because too much supply hit the market. Liquidity has been driven by the rally in the credit market more broadly, as well as by increased transparency," says Sal Cincinelli, CDO market specialist at SecondMarket.

He reports that listings on the SecondMarket platform have increased dramatically over the last few weeks, with activity focused on CLOs and TRUP CDOs. "Initially, trading was predominantly at the triple-A level but, as the CLO market rallied, liquidity flowed down the capital structure to single-As. Although most tranches are trading at distressed levels, triple-A prices recently jumped to the 80c region from the 60c region."

Structured credit analysts at JPMorgan note that demand is even strengthening for weaker double-A CLO tranches as investors look for bigger yields."In further evidence that the hunt for yield is broadening, [last] week we observed a strengthening in demand for weaker double-As with less advantageous event of default language; trading levels were in the US$40s to US$50s, depending on the transaction," they note. Single-A prices remain at around US$30, triple-Bs at US$12 and double-Bs at US$5, according to JPMorgan figures.

Sellers are typically those that bought paper through the SIV and market value CLO liquidations of last year, but who now want to take profits. Buyers, on the other hand, comprise some bank prop desks but are predominantly investors with the ability to drill down into the documentation and make their own recovery assumptions.

The SecondMarket platform has witnessed a wide range of bids and offers, reflecting the fact that each participant has their own opinion about what a deal is worth. According to Cincinelli, two factors are affecting CLO bid/offer spreads: event of default documentation and triple-C haircut provisions. At the double-A level, there is price differentiation between PIKable and non-PIKable tranches, depending on the vintage.

Prices are in the 20c-30c range for PIKable double-A tranches and in the 50c-60c range for non-PIKable double-A paper. "In non-PIK structures it is easier for senior noteholders to take control of the deal, as non-payment of interest constitutes an event of default," he explains.

In a recent special report Fitch warns that for CLOs any potential haircuts and treatment of PIK assets will remain transactionspecific and so investors should read the CLO documentation carefully. "For transactions that have the ability to invest in subordinated debt, if the PIK loan refers to a performing issuer (an IDR of single-B minus or above), the PIK can be held at par for the purpose of calculating O/C tests," the agency explains. "A haircut may apply for obligors rated triple-C and below or, otherwise, the PIK loan should be reflected at market value similarly to any other triple-C rated assets in the portfolio."

Similarly, European CLOs are bid lower than US CLOs because the underlying market is less liquid and less transparent. Trustee reports usually contain less information as the transactions are based on shadow ratings (as opposed to public ratings in US deals) and collateral pools have higher concentration limits. "The other factor impacting European spreads is the different bankruptcy regimes across the region, which means that recovery rates in Europe may vary significantly from those expected for US deals," notes Adrian Radulescu, head of the CDO desk at SecondMarket.

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