When the craze for CPDOs erupted in financial markets in late 2006, some observers quipped that these new products were like something out of a sci-fi blockbuster.
Leverage is key to deals’ profitable returns
Constant proportion debt obligations (CPDOs) were originally designed to make a highly leveraged bet on the performance of corporate debt in the US and Europe.
The standard early deals took exposure to the main investment-grade indices of credit derivatives – the iTraxx in Europe and the CDX in the US – which covered the 125 most actively traded companies in each region.
They earned premium payments for the protection they sold against default for the companies in the two indices.
The structure was designed to pay out a high fixed return over a 10-year lifespan. This was 2 percentage points annually over Libor, or the risk-free rate, for the very first deals, but the strength in credit markets at the end of 2006 meant that later deals could only earn enough premium to promise 1-1.5 percentage points over Libor.
The deals were also designed to profit from mark-to-market gains when the indices were refreshed every six months.
A key element of the CPDO structure was the prediction that applying high leverage in the early years would build up a pool of profits that would eventually cover all remaining payments due.
ABN predicted that for the first deal in August 2006 this “cash-in” point, when all the investors’ money would be moved into very-low risk government bonds or something similar, would be hit after about seven years on average, or three years ahead of maturity. However, one of the peculiarities of these deals was that if they lost money through defaults or a broad deterioration in credit markets, the CPDO would increase the leverage it applied to try to recoup that money.
This could give the deals the appearance of a gambler “chasing losses”, in the words of Cian Chandler, an S&P analyst, in an early comment on CPDOs and how they worked.
Paul J Davies
Not only was the ingracious acronym amusingly close to C3PO, one of the hapless robots from the Star Wars movies, but also like the heroes of Star Trek the products seemed “to boldly go” where no credit product had gone before.
