Investors in constant proportion debt obligations (CPDOs) were given an unwanted early Christmas present by rating agencies, as Standard & Poor’s (S&P) and Moody’s Investors Service put the ratings of CPDO notes on review for a possible downgrade.All 29 of S&P’s public CPDO ratings are now under threat. The agency pointed to factors such as spread volatility and correlation as being detrimental to the net asset values (NAVs) of the transactions it placed on review. It also said it was reviewing its own assumptions used in rating CPDO transactions, “to incorporate recently received information about deteriorating market conditions”.
Meanwhile, Moody’s has placed 11 corporate CPDO deals on review for a downgrade, comprising 35% of the total volume of Moody’s-rated CPDOs. Its explanation for this was more targeted, pointing to the increase in credit derivatives index spreads and the high levels of leverage among the transactions affected. All but two of them had 15-times leverage, according to Moody’s, and their NAVs had dropped by about 30% since closing.
CPDOs typically look to profit by selling protection on the credit derivatives indexes, closing out positions on the index roll and selling protection on the new index. This strategy usually pockets a small mark-to-market gain due to the longer maturity of the new series. The amount of leverage employed by the product is ratcheted up if the product is not making its allotted cash target, effectively doubling down on losses.
The idea of assigning ratings to CPDOs has long been the subject of market criticism, due to the product’s reliance on market – as opposed to credit – risk. This criticism could intensify after the most recent reviews put in place by the agencies.
The reviews come after UBS’s Series 103 Tyger CPDO notes were forced to be unwound during November, after the underlying portfolio hit the deal’s cash-out point.
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