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"CPDOs have performed exactly as we expected them to given current market conditions"
Steve Lobb, ABN Amro |
Not for the first time, constant proportion dynamic obligations (CPDO) have come under serious fire. Ever since it appeared on the structured credit scene a year ago, CPDO technology has drawn strong criticism for various reasons. One of the latest salvos came from independent credit research team CreditSights. Speaking at the IMN’s European structured credit and CDO conference in September, CreditSights analyst David Watts argued that the dynamics surrounding the roll into the new series of credit indices were extremely perilous for CPDOs.
"By having such a large number of names downgraded to below investment grade in the two indices [CDX & iTraxx] there has been a great deal of spread widening, which has caused mark-to-market losses for CPDOs. Ordinarily, spread widenings, while causing a loss for CPDOs, would also allow the instrument to earn more spread premium when it rolls into the latest index. However, because the downgraded names need to be removed from the indices the CPDO endures the mark-to-market losses but does not have the opportunity to recoup those losses. This reduces the CPDO’s ability to earn enough money to meet all of its obligations," Watts contends.
But the original structure’s proponents argue that detractors such as CreditSights are missing the point, because the first wave of CPDO structures are behaving exactly as expected under these conditions. Indeed Steve Lobb, head of structured credit marketing at ABN Amro, told Euromoney more than nine months ago that, although on a mark-to-market basis its first CPDO (Surf) would trade below par in the event of spreads widening by 100 basis points, the deal would perform in the long term on the basis that it would earn more income because of reinvesting in the next index at wider spreads (see Deals that changed the market in 2006: ABN Amro’s Surf constant proportion dynamic obligation, Euromoney, February 2007).
The first CPDOs are fixed-income products that use a constant proportion portfolio insurance framework to come up with a rated instrument – based on timely payment of coupon and principal. Through selling on-the-run five-year credit indices and using leverage multiples of 15, ABN Amro’s structurers were able to persuade the rating agencies to grant a triple-A rating on a 10-year maturity and still offer investors a spread of 200 basis points. This product seeks to take advantage of the gap between where spreads on the portfolio are and the expected loss due to default.
"CPDOs have performed exactly as we expected them to, given current market conditions. They are trading under par but this is broadly in line with other similarly rated structured finance products. The Surf CPDO could withstand over two more years of negative rolls such as the one we’ve just experienced and still perform. It is important to remember that because we are moving into a new spread level with the new indices, the CPDO will be accruing income at a much higher level going forward," says Lobb.
The original Surf CPDO printed at approximately 32 basis points almost one year ago. But because of spread widening, on the series 8 index Surf would roll out at approximately 65bp. That price depreciation is now reflected in the net asset valuation. The roll into the new index is somewhat tighter, approximately 58bp – income is now accruing at a much faster rate than when spreads were at 32 basis points. But one of the key CPDO assumptions is that credit curves are upward sloping, so spreads on the old index are meant to be lower than on the new index.
Lobb is not alone in holding the view that while wider spreads [on the latest index] do have a negative mark-to-market impact, these also enable the structure to generate higher income.
There are many factors that will affect the performance of a CPDO. "If we look at the impact of spreads only, then an early spread widening can be a benefit for the trade if it is able to capture these higher premiums. This can be achieved either by leveraging up or rolling into the higher spread environment," says Arthur Hatt, credit structuring at JPMorgan in London. "The extra future income can be a greater benefit than the cost of the initial mark-to-market loss. Of course this has its limits as if spreads widen by too much, the mark-to-market losses may cause a deleveraging of the structure. Also if you have spread widening coupled with defaults or decreased liquidity, then it is a different scenario."
Of course, defaults currently remain thin on the ground and, despite concern about economic growth because of the credit crunch, the default rate is not forecast to rise by much in the near future. Structurers have stress-tested the structure and even if this unusual event occurred at every roll they say it would cash in at par.
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Sharp fall in value of Tyger CPDO prompts UBS to restructure deal |
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NAV of Financial CPDO issued in early April |
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Source: Bloomberg, CreditSights |
But a number of investors, especially those with a track record in correlation products, didn’t buy into this innovation. Their concerns were numerous but largely centred on doubts about assumptions on the ability to roll into a new contract every six months, that the credit curve is upward sloping and – perhaps most important – that spreads are mean-reverting. Standard & Poor’s and Moody’s were implicitly criticized by Fitch and DBRS for their rating methodology – and indeed models were adjusted. And yet criticism of the performance of the early wave of CPDOs should be juxtaposed against other structured credit products, very few of which have escaped adverse effects from the recent market volatility.
"Like a CSO or any long credit product, a CPDO deal may trade below par due to market spread widening. Some products suffer more than others – both in CPDO and CSO formats," says Graham Murphy, synthetic structured credit at JP Morgan.