Structured credit: Banks rush to print CPDOs

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By:
Alex Chambers
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Few would have predicted that credit spreads could get any tighter but CPDOs further underpin the market’s strength.

Andrew Feachem, ABN Amro
“The evolution of CPDOs will likely follow what happened to CPPI and CDOs. You start with static deals and then you move to managed transactions. I think that will be the evolution”
Andrew Feachem, ABN Amro
The hype around one of the latest structured credit product innovations is understandable given the substantial advantages that ABN Amro was able to offer investors with its €1 billion print of constant proportional dynamic obligations (CPDO). The deal, called Surf, offered buyers a highly attractive coupon of Libor plus 200 basis points and yet is triple-A rated.

It sounds almost too good to be true – maybe it is – but the rating agencies have signed off on this structure, which involves selling protection in the investment-grade iTraxx Europe and Dow Jones US CDX indices. These indices have rallied dramatically in recent weeks, the cause of which is generally attributed to some pre-hedging of future deals. Anecdotal evidence suggests that approximately 10 deals are being prepared, probably for the new year.

It was probably this pre-hedging that resulted in an eight basis points tightening of the iTraxx Series 6 to 22bp during October. Consequently, some of the arbitrage that ABN Amro’s first CPDO captured, when spreads were above 30bp, has been wiped out.

The CPDO reverses some of the key technology used in credit constant proportional portfolio insurance. “We’ve been working on credit CPPI trades for over three years now,” says Andrew Feachem, structured credit marketing at ABN Amro. “That was a very innovative, interesting, trade for clients as well because a lot of clients have a lot of CDOs on their books and they are looking for ways to diversify. We felt that credit CPPI – by not having any direct correlation sensitivity – would be a good way of diversifying an existing structured credit portfolio.

Response

“One of the issues we’ve had with the regular credit CPPI for institutional clients is that it’s a total-return instrument, whereas for most of our fixed-income investors a defined cashflow and a rating is helpful. The first stage was getting normal credit CPPI rated but that was solving only half the issue. The other issue is converting what is a total-return asset into a fixed-income instrument. So CPDO was a direct response to the requirements of investors who were getting exposure to credits they are already familiar with but in a different way to a typical synthetic CDO.”

The CPDO effect
iTraxx tightening in October
Source: Markit Group

It has been a long time since synthetic CDOs have been easily able to offer such returns – most mezz CDOs would find it hard to squeeze much more than Libor plus 50bp and then investors would have to be comfortable with the default and correlation risk.

CPDO is a market-value or spread product. There is default risk but this is mitigated by rolling into the new on-the-run credit index every six months. Following the purchase of eligible (risk-free) collateral, the notional amount of the deal is then levered and then used to sell protection on indices. The ABN deal used a leverage factor of 15 times to produce a triple-A rated 10-year note and because index spreads were somewhere above 30bp, investors got 200bp. UBS analysts estimate that because of the leverage impact, €1.3 billion of estimated CPDO note results in notional credit exposure of €20 billion.

Step away

Mitch Janowski, head of exotic credit trading at ABN Amro, says: “Over the last couple of years, mezzanine and the top part of the [synthetic CDO] capital structure has tightened in tremendously and its purely a technical [feature] to do with correlation – ie, the fact that its been overbought. What the CPDO does is step away from that. It’s not a correlation-based product, it’s purely based on the spread of the underlying assets and the volatility of those assets. It’s another way of taking leverage. Recourse leverage versus non-recourse leverage.”

He continues: “It has an income stream of, say, 600bp but is only guaranteeing a coupon of 200bp. It’s really the timing of defaults that allows you to credit enhance to ensure that you reach Libor plus 200bp for the life of the trade.”

The structure incorporates several features to achieve the attractive coupon and triple A rating. Instead of the deleveraging when spreads widen, credit exposure is increased. CPDOs decrease leverage, ie, sell protection, when the market rallies. This dynamic leverage feature is key to generating coupon and principal but the leverage amount is capped. There are features designed to unwind the CPDO in the event that losses exceed a certain amount. Conversely, a cash-in trigger is reached if enough net asset value is created to pay the present value of principal and coupons.

It is also constructed as a duration play because although the investor is buying a 10-year maturity, that is investing in five-year underlying (the iTraxx/CDX).

“CPDOs are a new way of looking at an asset class, accepting a different style of risk in return for higher returns. You are taking on liquidity risk, you are taking on mark-to-market/market value risk and a bit more parametric risk around some of the assumptions that are being made. And at the end of the day you are X times long of the index. And you are saying that over a substantial period of time, that is, 10 years, credit spreads will be mean reverting and not too volatile and so will perform,” says Paul Levy, head of exotic credit structuring in the EMEA structured credit group at Merrill Lynch.

Evolution

ABN Amro’s bankers and others also believe CPDO is an efficient means to take leveraged credit in other asset class other than investment-grade credit.

“The evolution of CPDOs will likely follow what happened to CPPI and CDOs. You start with static deals and then you move to managed transactions. I think that will be the evolution next year. Then ABS, high yield and emerging market,” says Feachem.