CDOs: Axa turns back the clock

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By:
Alex Chambers
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Are structures like Jazz music to the ears of investors worried that the credit cycle will turn?

Lorenzo Isla, Barclays CapitalLorenzo Isla, Barclays Capital: sees substantial demand for managed CDOs
The threat of spread-widening continues to lurk just under the surface of benign credit market conditions. One of the unique selling points of a hybrid CDO, Jazz 3, managed by Axa and arranged by Merrill Lynch (neither of whom where able to comment on the deal) is that it counters that hazard.

The deal is positioned to take full advantage of the long-awaited downturn in credit and so should be ideal for investors worried about tight credits and the negative outlook, providing a compelling story for investors that fear history is repeating itself.

Jazz 3 is effectively a positive carry call option on future spread widening and future volatility. It is similar to a credit opportunity fund but the manager is using CDO financing to lock in tight liabilities for seven years.

The deal also marks a return to the old-style CDO technique where the arranger sells the complete capital structure, including all tranches of rated risk right from Triple As down to Double Bs and then equity. As a result Axa can invest in single-name CDS, bonds, total return swaps and loans that allow negative basis trades and various long/short strategies.

The lead raised €216.5 million and $379 million in cash. There is a funded part and a unfunded element. In addition to the notes sold, Ixis lends to the structure at Libor plus 12 basis points on a committed basis.

Axa is also investing in more defensive assets than a typical synthetic CDO. Some 97% of the assets are in the form of cash or CDS, with 3% single tranche equity. It is the higher returns from the equity tranche that allow the manager to be more defensive with the rest of the portfolio.

Until recently it was only synthetic mezzanine tranche CDO risk that was widely distributed. Lorenzo Isla, structured credit analyst at Barclays Capital, contends that now there is greater interest in synthetic equity tranches from traditional fixed-income end-investors. “This is something we can quantify in different ways,” he says. “Volumes have grown significantly over the past months.” According to Isla, the number of bespoke equity transactions in the first half of 2005 was north of 400 whereas for the whole of 2005 there were only about 350.

“There are different ways to get exposure to corporate credit,” says Isla. “One is outright but most people take the view that the risk premium in corporate credit securities is relatively low. Furthermore, spread premiums in traditional CDO securities are low as well. For these reasons investors are interested in CDO equity, which does come with risks attached. For instance there is significant tail risk and correlation risk. But what investors are doing is scaling their equity investment appropriately and putting it into a credit portfolio. “So we are seeing some insurance companies allocating part of their corporate credit portfolio to CDO equity.”

CDO equity has generally been bought by hedge funds or retained by the dealer. Jazz 3 enables other investors to take a similar approach to what Isla describes above but under the protection offered by an experienced manager.

“The other thing I think this transaction represents is that there is substantial demand for managed CDOs,” says Isla. “The proportion of managed structured finance product as a percentage of overall synthetic issuance has gone up substantially.”

Managed synthetic CDOs have other benefits over bespoke static synthetics, such as less volatility and greater secondary liquidity. They are also securities whose valuation is not reliant on an individual firm’s model.

Axa also has a track record of trading under testing credit conditions. Jazz 1, the very first synthetic corporate investment-grade CDO that Axa managed, printed in 2001 which was just about the worst time to be taking a leveraged view on corporate credit. But it was one of the first CDOs to have flexibility in the structure that allowed the manager to reposition the composition of the portfolio to take advantage of the dramatic spread widening that happened in 2002.

Just as in 2001, the market has ceased to differentiate between different categories of risk. Despite triple Bs being 2.5 times riskier than single A, investors are receiving very little extra return for the extra probability of default. In Jazz 3, unlike the portfolios of most investment-grade CDOs, which are BBB, or even a BBB–, the average spread is on the cusp of single A/triple B. The history of spread migration under a widening environment points to decompression; that means the triple Bs will go from 70 basis points to 150bp but the single As only from 40bp to 80bp, meaning that Jazz 3 is already defensively positioned to outperform.

In the current market conditions it is quite possible to put together an aggressive structure that would give a 20% return on equity, assuming zero defaults, but instead the base case expected return on Jazz 3 is mid-teens. What is the upside from giving up that potential 500bp extra? A greater chance of making more money if the market has a widening event during the next seven years, something that few would bet against happening.

There are a lot of investors worried that there is a high potential for spread widening but don’t feel assured by long/short structures. It is not easy to make money by being short because if the timing is out then it’s very costly because of the cost of carry.

Jazz 3 is not a short structure but because of the positioning of the portfolio and flexibility to churn the portfolio it should perform in a widening environment. The structured credit market is heralded for its flexibility in providing arrangers with the ability to structure tailor-made to the particular views of investors. This is further proof that there is an investor base that believes there could be a continuation of the good times but the cycle will turn at some point. But who can tell when it is going to happen?

Equity will not limit the size of the deal. The arrangers went out with intentions to do €1.5 billion but there is enough equity for €3 billion. But there are liquidity lines, and there is debt, including super senior, which raises the question of how much is feasible to expect the manager to handle.