Collateralized debt obligations have been a part of the structured credit landscape for over a decade. In recent years, new-issue volumes in the cash markets have risen considerably. Global cash and synthetic CDO issuance exceeded $100 billion in 2003, the third highest level since the early 1990s. Growth in euro-denominated CDOs continued and euro-denominated issuance now makes up about 35% of total CDO volume.
With the introduction of synthetic structures, a morphing of credit derivatives and securitization has taken place, further boosting market growth. Synthetic CDO transactions have expanded rapidly recently with issuance growing by 104% between 2002 and 2003 to make up 26% of the market.
We expect issuance in this asset class to persist as participants continue to find synthetic technology an effective mechanism to hedge credit risk. Liquidity has also improved due to multiple factors including hedge fund participation in correlation trading, single-tranche deals and new product innovations such as index tranches, structured product CDOs and constant maturity technology.
In addition, the advent of managed synthetic structures has reduced some of the inherent risks of static structures including the impact of unforeseen credit deterioration on the collateral pool. Recent advances in the fee structure of CDO managers have helped to better align the interests of the manager with those of the mezzanine holders.
Credit risk premiums, diversification and CDOs
The increasing popularity of this asset class therefore begs the question: what makes CDOs an attractive investment? The answer effectively comes in layers. A well-known secret of the credit world is that the market charges a substantial risk premium for credit-sensitive instruments. Default probabilities inferred from market spreads are large—often multiples of the historical default rates reported by the major rating agencies. This seems to encourage a buy-and-hold strategy for investors with unusually high expected returns.
However, this apparent ‘free lunch’ brings with it significant (and often overlooked) risks: mark-to-market volatility and the asymmetry of the return profile. Conventional wisdom would have diversification as the ultimate answer to mark-to-market volatility and as a partial answer to the asymmetry of the return profile. But diversification comes at a cost, in human and material resources, and is often out of reach or impractical for many investors.
CDO investments provide an answer to the diversification issue and, we believe, a cost-efficient one. Through subordination, a CDO achieves rating enhancement by tranching and redistributing risk, while maintaining a diversified exposure to the underlying collateral pool.
With the introduction of CDOs, investors need not create their own portfolios and manage them for credit quality and risk exposure: they simply acquire diversification through CDO tranches. Tranching can help smooth out loss distributions. For individual credits, the loss profile is bi-modal: bonds, for example, either survive and pay par at maturity or default and pay an uncertain recovery rate before maturity. A CDO tranche offers a graded loss distribution: as the tranche is part of a portfolio, the ‘all-or-nothing’ characteristic of single-name credits can be dampened significantly.
CDO tranches offer excess spread relative to equally rated traded credit default swaps or bonds. Free lunch? Not really. Just as subordination enhances ratings, default correlation enhances spreads. Any investment based on a portfolio of credit instruments must take correlation effects into account. Zero correlation implies ultimate diversification, while a high correlation effectively negates the virtues of diversification.
When rating agencies assign a rating classification to a given tranche, correlation assumptions are made consistent with historically observed correlation, which is typically low. Market-traded tranche spreads, on the other hand, are set using a higher implied default correlation, thereby offering enhanced spreads.
The relentless drive for diversification and return has led to further innovation in the CDO market. Structures in a spectrum of increasing sophistication have surfaced to address both of these issues. Synthetic structured product CDOs are similar in structure to standard synthetic CDOs. Like their corporate counterpart, synthetic structured product CDOs usually have a large ‘super senior’ tranche above a small triple-A tranche, followed by a double-A, single-A and first-loss layer.1
In the case of squared collateralized debt obligations, the collateral pool consists, for example, of single-A tranches of other synthetic CDO deals. As each component of a squared CDO pool is itself a senior tranche of the capital structure of another CDO, the effect is to offer a double subordination with the aim of maintaining high returns stemming from higher tranche spreads than would otherwise be achieved with similarly rated individual corporate names.
Most squared CDO deals include clauses that prohibit the same credit from appearing multiple times in the totality of the underlying collateral pools. This effectively achieves a considerable increase in diversification that is otherwise unattainable with plain synthetic CDOs. CDO-squared deals have been placed with collateral pools of as many as 400 reference names compared with 100 names for typical standard CDOs. In addition, higher tranche spreads are generated by leveraging correlation rather than default risk as is done in a standard synthetic CDO structure.
Investors with a constructive view on credit, but who nevertheless believe the rally in spreads is overdone, will naturally be looking for opportunities to invest in floating spread products. This has been rendered possible recently through the introduction of constant maturity credit default swaps (CMCDSs). Through a combined strategy of CMCDS and CDS, a decoupling of default risk and spreads is within reach.
The extension of the floating-rate, constant maturity technology to correlation products comes in the guise of constant maturity collateralized debt obligations (CMCDOs). In a CMCDO, the spread earned by the various tranches is not preset. The investor earns a multiplier, known as the participation rate, of the average constant maturity spread of the collateral pool.
As in the traditional structure, CMCDOs offer the possibility of mitigating default risk and expressing a view on spread level and slope. In a market sell-off, the (floating) spread paid by a CMCDO tranche increases, a benefit over the standard tranche. Obviously though, in a market rally, the floating coupon goes down but the subordination of CMCDO tranches becomes more valuable. CMCDS technology allows investors to put capital to work, earn good carry and still retain the possibilities of achieving the yields of 2003, should the market back up.
Credit fundamentals and outlook
The CDO sector experienced heightened volatility between 2000 and 2002 with corporate event risk leading to an unprecedented level of downgrades. As we look to 2004, we expect the sector to turn around with incrementally stronger demand for CDO paper as the credit cycle improves.
Furthermore, a positive environment for credit spreads tends to drive default correlation risk down—lower correlation levels are materializing in the index volatility products offered in the equity markets. Downward moves in default correlation are typically constructive for lower-rated tranches of CDOs.
The demand for tranched risk of diversified pools continues and, in our opinion, the increase in the number of active CDO desks should keep supply numbers trending upward. It is worth noting that liability spreads have trended tighter but at a slower pace than the underlying credit assets, which bodes well for CDO products.
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Jean-Paul Calamaro +44 (20) 7545 1555
Tarek Nassar +44 (20) 7547 1215
Anthony Thompson +1 (212) 250 2087