Are yield-starved credit investors over-indulging in leverage? “Constant proportion debt obligations” are the latest must-have for those dissatisfied with the paltry returns from traditional investments.
CPDOs take credit exposure in the derivatives market of up to 15 times the amount invested. The complex structures involve selling credit default swap protection on corporate credits using, for example, European iTraxx index contracts. Piling on leverage amplifies a meagre return of roughly 0.25 per cent a year to nearer 4 per cent. That covers the cost of the transaction, a healthy return to investors and a cushion. Meanwhile, investors’ money is in the bank earning interest. Early deals promised buyers a whopping 2 percentage point premium over Libor on structures that, partly thanks to the return cushion, were rated triple-A.
If everything goes smoothly, leverage falls as the instrument accumulates excess returns. Once it is sufficiently well funded to pay everyone over the instrument’s life of, say, 10 years, it holds just cash. But the reverse is also true. If a CPDO makes losses because of unexpected defaults or a worsening credit outlook, leverage can rise, up to a cap, in an effort to “win back” any shortfall. If the market goes the wrong way, that amounts to throwing good money after bad. That has not deterred investors. Their appetite for CPDOs and other credit exposure has driven the cost of protection on the iTraxx and the comparable US CDX index to fresh lows – making the potential returns from new CPDOs slightly less generous, unless even higher leverage is employed.
Credit derivative spreads have, unusually, fallen below risk premiums on the bonds that underlie them. This “negative basis” presents bond investors with a genuine arbitrage – the opportunity to buy bonds, hedge the exposure almost perfectly with derivatives, and still earn a return. But it also reflects investors’ quest for yield, almost irrespective of risk. Even the clever structuring behind CPDOs will not shield their owners from the pain of a turn in the credit cycle.