Credit derivatives: Squeeze is over for EM CDOs
Emerging market CDOs look more attractive after the recent market correction.
|“Investors are getting a huge amount of leverage and they are comfortable taking the risk”
Sajid Javid, Deutsche Bank
The recent correction in the bond markets could prove to be a boon for emerging market CDOs, according to bankers. A few synthetic deals are in the pipeline, including one being arranged by Goldman Sachs that would be the first single-tranche local-currency CDO in the emerging markets. That deal is expected in the third quarter. Bankers are also thought to be in the preliminary stages of arranging balance-sheet-driven CDOs including Russian and Saudi Arabian credits. If these transactions come to light, they will follow a €227.5 million-equivalent, five-year static synthetic CDO that was arranged by Citigroup and issued by Salisbury International Investments last month. Salisbury is selling protection to the swap counterparty on a portfolio of 100 emerging market credits, comprising 80 corporate and 20 sovereign entities. The portfolio encompasses a range of sectors, and reference credits were selected from 34 countries in each emerging region.
Also last month Deutsche Bank closed a $500 million emerging markets CLO. The deal is the first of its kind because it hedges highly illiquid loans on the bank’s loan exposure management group’s balance sheet. Craft EM CLO 2006-1 will facilitate new lending by Deutsche Bank to local companies based in emerging markets.
Revived investor appetite
These deals were placed after investors had come to feel comfortable that the recent sell-off in the emerging markets had ended and as the asset class proves attractive to them again in their search for yield. Ante Razmilovic, head of structured credit marketing at Goldman Sachs, says: “The rally in emerging markets squeezed a lot of interest from investors but now there are significant opportunities for further transactions.”
Sajid Javid, global head of emerging markets structuring at Deutsche Bank, agrees that the [recent] correction acted as a positive for emerging market CDO products. “It was not big enough to put off current investors but sufficient enough to attract new ones.”
Javid reckons that the credit environment is now conducive to more emerging market CDO structures. “You want an environment where the underlying fundamentals are strong but where there is sufficient value vis-à vis other asset classes.”
He points out, for example, that Turkey’s five-year CDS is trading at 260 basis points over the equivalent swap rate compared with a low of 150bp over before the sell-off (though during the turbulence the spread widened out to as high as 320bp over).
Some analysts, however, reckon that spreads are still too tight for the asset class to develop quickly and that cash CDOs, in particular, are off investors’ radar screens because the arbitrage is not attractive.
Another possible stumbling block is the risk associated with emerging markets. However, with improving economic fundamentals and stronger governance standards in the developing world, bankers dismiss the notion that the asset class should not be included in CDO structures. “As long as investors understand the risk/ rewards of an emerging market CDO they are very appropriate,” says Javid. Moreover, he adds, emerging market CDO portfolios tend to have a heavy sovereign focus and while governments may default they are unlikely to go bankrupt. Sydbank, for example, which has issued two emerging market synthetic CDOs, chose purely sovereign credits in both deals. For the ratings agencies, the methodology used for assessing the default risk of emerging market credits is no different from other asset classes, says Hervé-Pierre Flammier, a director at Standard & Poor’s.
One big difference between an emerging market deal and other asset classes is the equity content. “An emerging markets CDO would have maybe a 15% to 20% equity portion,” says Javid, “while for an investment-grade corporate transaction it would be about 2%. Therefore investors are getting a huge amount of leverage and they are comfortable taking the risk.”
The first public emerging market CDO was placed about 18 months ago for Sydbank via Goldman Sachs. Since then a spate of transactions have come to market, some proving more successful than others. In the third quarter of last year, for example, Pimco issued a 10-year single-tranche synthetic CDO, also through Goldman Sachs, that has been tapped 10 times since November.
The transaction is now just shy of $800 million, making it the biggest emerging market deal. “The reputation of the manager is very important to the success of the deal,” says Jon Donne, structured credit marketer at Goldman Sachs. What made the Pimco transaction stand out even more was the range of investors it attracted – specialist synthetic buyers, dedicated emerging market players and, uniquely, US pension funds. These investors rarely buy single-tranche synthetic CDOs because of regulatory constraints.
Another successful deal placed in the past 12 months was a 10-year, $120 million synthetic multi-tranche CDO managed by Ashmore via Deutsche Bank. The deal was innovative in that it’s a quasi-static portfolio – namely Ashmore can’t change the whole portfolio but it can change a handful of credits in the pool each year.