When a new complex credit product hit the headlines at the end of last summer, it unleashed a wave of trading in credit derivatives indices in the expectation that a flood of similar, highly leveraged deals would soon come to market.
But the flood never really emerged, as only €4bn–€5bn ($5.3bn–$6.6bn) worth of deals ever saw the light of day – although the use of leverage of 15-times principal meant they were responsible for up to €75bn of trading volumes.
In the event, the hype surrounding these so-called constant proportion debt obligations (CPDOs) helped to drive risk premiums in credit markets to ever-lower levels, ruining the economics of many planned deals. Meanwhile, the rating agencies, which are key to creating the products, reassessed how CPDOs should be rated as they were bombarded with new types of structures.
Now, the next wave of CPDOs is set to be unleashed – and the step-up in complexity and ambition of the new generation is likely to leave some investors’ heads spinning.
The central development in the first CPDO was the application of a credit rating – such as is given to ordinary company debt – to the market value of a series of highly leveraged bets on credit derivatives indices.
What this meant was that the agencies were giving a rating to a trading strategy, says Steve Lobb at ABN Amro, which invented the product.
“When agencies started rating market value in the context of CPDO, the key thing was that they were actually rating a trading strategy,” he says.
The first generation centred around a trading strategy that relied on credit risk premiums remaining benign for some period of time. Some investors, however, might hold a different view, with concerns about short-term volatility and an increase in defaults. However, Mr Lobb explains that if the CPDO trading strategy took account of such views, it would feed into the original rating model for the products, meaning that the results and potential returns could be somewhat different.
“This is why the agencies took a step back at the end of last year to re-evaluate their models and some of the new trading strategies that were being brought forward by arrangers.”
ABN’s next deal tries to tackle some of these dynamics by using leverage that begins at a much lower level in order to guard against large losses if there is a significant widening in credit spreads in the short term. The leverage is increased once spreads widen out to pre-defined levels.
After the hiatus in deal flow at the end of last year, the rating agencies have been ploughing through many of the new proposed structures. “It has been a very busy seven months on the CPDO front,” says Paul Mazataud at Moody’s. “All transaction proposals are different and our analysts are working night and day to model each deal proposal.”
The agency is working with numerous banks on various deals – from those that are purely model-driven to ones that have some form of manager involvement. Only a handful are expected to emerge in coming weeks, however. Mehdi Kheloufi-Trabaud also at Moody’s says only six banks are proposing versions where a manager will put together a portfolio of underlying assets rather than using the credit derivatives indices.
Some of those are talking about managing both the portfolio and the way leverage is applied, he says.
This week, Lehman Brothers and Pioneer closed the first deal that involves some management, although it will use the indices for its exposure rather than building a bespoke portfolio.
In this deal, the manager can change the leverage depending on his market view and also choose to invest in say seven- or 10-year versions of the indices rather than the five-year version. The manager will also be able to place some short trades on individual companies to guard against blow-ups.
“In the first generation of CPDOs, many investors were sceptical about relying solely on an algorithm for investing in credit over a long period,” says Francesco Cuccovillo at Lehman.
“We could possibly work with bespoke portfolios as well, but I think demand from investors is with index-based products for now because liquidity is the major concern.”
However, UBS and Blackrock are working on a much more complicated beast for which they have even invented a new acronym, the MVIP, or market value investment platform.
Paul Czekalowski at UBS says this deal should allow the manager to make bets on indices of different duration, place long and short positions on individual companies and make so-called “curve trades”.
These involve exploiting relative value differences between indices of different maturities by for example shorting a three-year index while going long on the seven-year version.
A deal such as this would take the idea of rating a trading strategy a stage further, by applying a rating to a group of strategies – or the returns profile of an asset manager. This has the potential to open up all asset classes from commodities to equities for use in CPDOs.
“There is a lot of interest in getting fund returns rated,” says Mr Czekalowski. “I think for now, the agencies are starting to experiment with applying this idea to funds that invest 100 per cent in fixed income because that is where you get the underlying steady cash flows.”
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