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Satyajit Das looks at the structure, economics and market for CPDOs
The structured credit markets have emerged as a significant source of yield and return enhancement for investors. A primary feature of structured credit is the use of leverage to enhance returns. Constant proportion debt obligations (CPDOs) are the market's latest effort at using leverage to increase returns for credit investors1.
CPDOs emerged in 2006. The originator of the idea is believed to be ABN AMRO. The product was driven by a combination of factors including:
• A benign credit environment characterised by low levels of default and strong corporate profitability, cash flows and balance sheets.
• Decreasing corporate credit spreads driven in turn by the credit market conditions and a marked imbalance between credit investment capital and available credit assets.
The product was also driven by some more idiosyncratic factors. In 2005, temporary dislocation in traded credit markets allowed investors to create triple-A high yielding credit assets – Leveraged Super Senior Notes2. The downgrade of General Motors and Ford to non-investment grade and the resulting change in traded credit correlation enabled investors to generate returns of LIBOR plus 50bp and above on triple-A assets.
The correction in that market limited the opportunity to continue to use that structure to generate high returns. The CPDO is targeted at these investors seeking triple-A rated assets at higher returns than available in the market.
Structure
The basic idea underlying the CPDO structure is a highly leveraged trade on selected credit indices.
The basic elements of the structure are as follows:
• The structure is fully funded. The investor purchases a note (say US$100m) with a final legal maturity of 10 years. The note is rated triple-A by the rating agency. However, the principal and interest of the note is not specifically guaranteed.
• The Note pays a coupon of around LIBOR plus 200bp pa. The economics of the spread rely on leverage (as detailed below). The leverage typically deployed is around 15 times.
• The dealer structuring the CPDO hedges as follows:
1. Dealer invests the US$100m in high quality collateral.
2. Dealer sells protection on US$1,500m notional on credit indices – typically, the DJ CDX IG-7 and the iTraxx.
3. Dealer must re-balance the hedge every 6 months by rolling the credit index position to the new series of the index.
• If there are no losses, then the investor receives full return of principal invested. However, if there are credit events on the names in the index, then normal settlement is effected, lowering the principal returns to the investor.
• The structures have a natural "defeasance" or "cash-in" effect that may reduce the "economic" life of the transaction.
Economics
The primary driver of the economics of the CPDO structure is the significant leverage utilised. The economics can be illustrated with a hypothetical example:
• Assume the example above - US$100m 10-year note. The note principal is placed in high quality collateral. Let us assume it earns money market returns at LIBOR flat.
• The investor is selling protection on US$1,500m on the 10 year selected credit indices. Assuming the spread on the index is 35bp pa. The investors earns 525bp (35bp x 15).
• Investor receives LIBOR plus 200bp pa on the CPDO.
• Assume the arranger receives 60bp pa.
• The net position is 265bp (525 - (200 + 60)).
• The excess spread is set aside to cover certain costs:
1. Roll costs (as index is reset)
2. Mark-to-market costs.
The defeasance/cash-in effect inherent in the CPDO structures is predicated on the net spread. The excess net spread (after adjustment for the costs that must be covered) builds up over time if there are no defaults.
This creates a buffer that prior to scheduled maturity covers the remaining coupons and fees. It effectively defeases the outstanding interest owed, allowing the transaction to be cashed in before the final legal maturity.
In a typical structure, the model indicates:
• 50% probability of being cashed in after 5 years.
• 75% probability of being cashed in by 7/8 years.
The economics of the cash-in can be illustrated (using the previous example):
• If we assume the 10-year swap rate is 4.85% pa, then the present value of the spread (200bp pa) is US$15.56m.
• The net spread (assuming no defaults) is 265bp pa (US$2.65m). This equates to a cash in target of around 5.9 years ((US$15.56/US$2.65).
Analysis
The value in the CPDO relies on using a highly leveraged structure to monetise an expectation of no defaults (specifically early defaults) in the underlying credit risk assumed.
The primary credit risk mitigation is based on:
• Diversification - credit is diversified through selling on 250 names (equally weighted between CDX IG-7 and i-Traxx).
• Rolling the index – the requirement of semi-annual rolls to a new series of the underlying credit indices is designed to reduce credit risk. In effect, the rolls should lead to the less liquid and deteriorating names dropping out every time the index rolls. This should reduce the risk. In effect, the investor's risk is always to the default of any one name in the portfolio within the relevant six month period.
A major attraction of the CPDO is its triple-A rating. The rationale for the triple-A rating is clearly the perceived low risk. This low risk is as a result of the investment grade underlying credit risk of the portfolio.
This risk is mitigated via the rolls, which, as noted above, limits the risk horizon to 6 months. Rating agency stress tests obviously support triple-A probability of repayment of coupons and principal.
The leveraged structure means that the investor is effectively providing the highly levered equity on a large portfolio of credit risk. The structure carries significant credit risk: (1) event risk (an investment grade credit defaulting unexpectedly); and (2) credit cycle risk (rising default rates as a result of an overall weakening in the economic and credit conditions).
It is not clear how the structure will perform where defaults occur and the credit environment weakens significantly. It is likely that in those conditions, the CPDO itself will have significant rating downgrade risk.
The level of credit risk in the structure is easily discernible. Assume 1-3 defaults per year over 5 years with 40% recoveries. The economics of the CPDO (using the previous example) is apparent.
Each default equates to 0.40% of portfolio (1/250) before recoveries. The loss after recovery is 0.24%. This is equal to US$3.6m (calculated as US$1,500 m x 0.24%). This means that 3 losses equal US$10.8 m to be covered from the net spread (US$2.65m pa).
The CPDO structure also carries maturity and liquidity risk. Investors also find the "projected" term (shorter than the final 10 year maturity) of the CPDO attractive. This assumes early defeasance. However, early defaults will means that leverage will not come down and the term will lengthen.
The investor in the CPDO also has significant liquidity and related spread risk. This is related to the required semi-annual rolls. The investor is fully exposed to the impact of liquidity and roll costs every 6 months when credits drop out and are replaced. The high leverage of the structure means that US$5bn of the CPDO issues creates US$75bn of index selling and rolls.
The CPDO structure assumes modest roll costs (around 2bp). The assumed roll cost may be low. In addition, under stress conditions in the credit markets, it is not clear whether the rolls are feasible. In this context, it is useful to remember that the market credit indices and trading in instruments based on the indices is a relatively recent and untested.
The investor is also exposed to the impact of spread changes on each roll date. This may increase the credit spread accruing to the investor (if market spreads widen) or decrease the return (market spreads decrease).
However, the bigger effect of credit spreads changes will be on the mark-to-market of the CPDO notes themselves. Small changes will effectively be magnified by the high leverage employed. Rising defaults and the simultaneous increase in credit spreads may trigger large losses (both realised and mark-to-market) in the CPDO.
Market
The CPDO market has attracted significant interest. It is assumed to be a factor in falling credit spreads in the market. As at November 2006, volume of CPDOs issued were estimated at around US$1.5bn to US$2.0bn. There are already signals from the rating agencies that the levels of fees and leverage used may need to be lower to achieve triple-A ratings.
The CPDO is an interesting innovation that uses the precedent of the Leveraged Super Senior Note to increase leverage to enhance yield at the highest end of the credit spectrum. Such trades are attractive in the benign credit conditions that have prevailed in recent years, but may well prove significantly less attractive in more hostile credit market environments.
Notes
1. See Consoli, Victor (31 October 2006) "Views Across The Grade: Levered CDX Index Notes Have Been Compressing CDS Spread"; Credit Strategy and Economics, Bear Stearns, New York; Davies, Paul J. "Questions Lie Beyond CPDO Hype" (14 November 2006) Financial Times.
2. See Das, Satyajit "CDO Structures – New Investment Products" (December/ January 2006) FOW 45-48.
© 2006 Satyajit Das All right reserved.
About Satyajit Das
Satyajit Das works in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management. His works include Swaps/Financial Derivatives Library – Third Edition (2005, John Wiley & Sons) (a 4 volume 4,200 page reference work for practitioners on derivatives) and Credit Derivatives, CDOs and Structured Credit Products –Third Edition (2005, John Wiley & Sons).
He is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall), an insider's account of derivatives trading and the financial products business filled with black humour and satire. The book has been described by the Financial Times, London as " fascinating reading ... explaining not only the high-minded theory behind the business and its various products but the sometimes sordid reality of the industry".
He is also the author (with Jade Novakovic) of In Search of the Pangolin: The Accidental Eco-Tourist (2006, New Holland), an unique travel narrative offering passionate and often poignant insights into the natural world and the culture of eco-travel.