Deal: Apollo CCO
Structurer: Barclays Capital
Date Announced: December 7 2004
Barclays Capital issued the first collateralized commodity obligation (CCO) last month, providing fixed-income investors with access to commodities as an asset class. Historically, collateralized debt obligations (CDO) have used bonds, loans or credit default swaps as the underlying asset. This variant uses derivatives technology to create a debt-style pay-off for a different asset class, giving investors exposure to a basket of commodities in an established fixed-income format.
The commodities in the CCO, named Apollo, comprise energy, base metals and precious metals, including gold, silver, aluminium, copper, as well as Brent, heating oil and natural gas. The vehicle will have a similar template to traditional collateralized synthetic obligations (CSO), with tranches ranging from equity to Triple A and super senior. However, the underlying derivative assets are commodity trigger swaps (CTS). Their ?trigger events? will be determined by a change in commodity price levels, making payment of the principal of the CCO subject to any price movements of the underlying commodities included in the basket.
There are 10 trigger swaps per commodity, with triggers ranging from 65% of the commodity spot price at transaction closure down to 20%, with a 5% separation between trigger prices. Each trigger swap can only trigger a loss at the end of the five-year period and the payoff is a fixed sum, regardless of the level of the relevant commodity after five years. So a trigger event can cause a loss of capital but no impairment of coupons, thereby structurally guaranteeing them.
The obligations will be issued by Belo, which was set up as a limited liability company in August 2004. The proceeds of the note will be passed on to Barclays Bank as a swap counterparty to fund the commodity trigger swaps (see chart for the structure of the transaction).
Matt Schwab, director in commodity structured products at Barclays Capital, says that the CSO technology seemed the most attractive structure for this product for two key reasons: ?Firstly the technology itself is extremely flexible and it is an investment vehicle that is already familiar to investors and ratings agencies. We have therefore been able to leverage off the fact that this investment vehicle is widely recognized.?
In the past commodities markets haven't been very good at providing investors with investment vehicles but, in the past few years, there has been acceleration in both retail and institutional investment in commodities as an asset class. ?A large sector of the investment universe thinks about risk and reward in the form of spread ? if you buy a corporate bond, you get a spread reflecting the company's credit risk,? says Schwab. ?Investors began to ask if you could apply this concept to commodities.?
The importance of rating
This is the first synthetic CDO of commodity trigger swaps rated by Standard & Poor's, receiving a preliminary AA rating. ?It was very important to us that the CCO was rated,? says Schwab. ?This is because the same investor universe who thinks about risk and reward in spread terms tends to categorize risk using publicly available ratings. In many cases these investors can only invest in rated vehicles ? something which precludes traditional commodity investments.?
However, S&P had to develop a new methodology to assess the risk in the portfolio as it couldn't use its standard default tables. The product is static and Schwab argues that this structure was chosen because a managed structure would require a manager with both a CSO and commodity background. ?This is a rare combination,? he adds.
As part of Standard & Poor's methodology for assessing the risk, a moving average filter is applied to the selection of commodities that are included in the basket. If the one-year average spot price of a commodity is greater than 50% of the five-year average of that commodity, it must be excluded from the basket. For that reason, nickel and lead cannot be included in the portfolio at the moment, although it is expected that nickel will come back into the portfolio over the next few months.
?This rule is designed to minimize the possibility of investors selling risk against price falls in a commodity during a temporary spike in that commodity,? says Schwab. ?It reduces risk but at the same time is flexible enough to allow a commodity to come back into the portfolio if it demonstrates a protracted price rise.?
The product targets credit investors in the US, Europe and Asia, ranging from commercial banks and hedge funds across to more conservative-style investors such as
public insurance companies.
Barclays expects that there will be more deals like this over the course of the year, utilizing different commodities such as grains and livestock. ?It's boring for investors if the same product is launched over and over again,? says Schwab. ?The beauty about this investment vehicle is that the technology is flexible.?