Managed CDOs from Cheyne Capital Management and Axa Investment Managers have pushed structured credit technology in new directions as investors look for enhanced yield in a tight credit spread environment.
Cheyne Correlation CDO 1 combines cash and synthetic CDO structures. It is a managed cash CDO of static single tranche CDOs.
CDO investors increasingly want a say in the composition of underlying portfolios. On Aria, Simmons & Simmons gave legal advice to arranger CSFB. ?Last year... investors had less time for static deals, because they have no way of preventing losses that arise out of credit events,? says Simmons partner David Roylance.
This explains the growth of private, single tranche CDOs designed for specific investors, who are given substitution rights to manage the underlying portfolios. It is also why the performance of portfolio managers on public deals is closely scrutinised.
In Cheyne Correlation CDO 1, the underlying single tranche CDOs are sold into an SPV, as in a cash deal. But single tranche CDOs are relatively illiquid. If Cheyne cannot easily trade them in or out of the portfolio, it needs another way to manage the credit risk.
?What makes Cheyne unique is that this risk is managed using synthetic CDO technology,? says Roylance. Cheyne can look at the hundreds of names in the portfolios of the single tranche CDOs and buy credit protection on any them through a credit default swap with CSFB. Cheyne is the first CDO squared deal based on single tranche CDOs where the underlying reference entities can be hedged individually.
Although it primarily buys protection on behalf of investors, Cheyne can short the credit within certain limits. The static nature of the underlying CDOs is an added reason for investors to want to manage their credit risk defensively.
Cheyne Correlation CDO 1 sold five different tranches of debt in a public deal that included a dual 144A/Regulation S placement. The notional value of the deal is $300 million.
Axa got its own innovatively structured deal away last month when it launched Aria CDO 1. Aria CDO 1 is a collateralised swap obligation (CSO). CSOs have credit default swaps as their underlying asset.
Aria is Axa?s fifth CSO. It mimics last year?s Overture deal, which was the first syndicated public CSO, in selling the bonds through a syndication. But Aria is a single tranche deal.
Combining single tranche structural flexibility with syndicated distribution helps sell the deal. Subordinated tranches can be managed internally if investors don?t want them. The deal size can be raised with investor demand. And because in a single tranche deal each note can be tailored to investors? wishes, Aria is a multi-currency deal.
The £200 million ($364 million), AAA sterling tranche is a breakthrough. Because Aria is a single tranche deal and the banks don?t have to sell the full capital structure, they can target sterling investors who have been unwilling to buy the equity portions of public CSOs.
As on Overture and Cheyne, the manager can enter short positions by buying protection. ?The portfolio manager has considerable flexibility in trading,? says Standard & Poor?s analyst Matthew Wiesner. Short positions are limited to 10% of the portfolio notional.
Uniquely, Aria has a two-year period to valuation following credit events. Usually, the period to valuation is between 45 and 100 business days. ?The long period to valuation gives the portfolio manager greater flexibility in choosing when to value any defaulted obligations,? says S&P?s Wiesner.
If a manager has to find a bid for a defaulted name immediately, it can leave the investor at a disadvantage because swaps typically trade very low until the implications of a default are clear. With a longer period to valuation, Axa can work the CDS out of the portfolio as it would with a corporate bond.
Historically, better recovery rates are achieved with longer periods to valuation. Aria also incorporates simulated physical delivery of credit-defaulted assets.
JPMorgan was global co-ordinator and lead manager on Aria. It printed about 89 tickets for 59 investors. While a number of investors were repeat buyers from Overture, around one-third were buying into their first structured credit deal. JPMorgan and its selling group sold the deal across 15 countries. The most receptive market for synthetic structured credit until now has been Europe, so US and Asian distribution is significant. Aria is making CSO technology available to a global investor base.
Investors that have got into the structured credit market should stay there. If they do, new banks will try to structure and sell deals. But the likes of JPMorgan, with their quant and trading skills and developed risk books, should enjoy a competitive advantage.
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Aria?s reference pool By country
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Source: Standard & Poor?s
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