The last few months have seen massive downgrades of constant proportion debt obligations (CPDOs), but the worst could be over for the sector.The rating agencies that originally gave the structures AAA ratings have become more pessimistic, downgrading almost the entire CPDO market. They cite fears that the products might not be able to build value sufficiently to cash in, that is, to reach a net asset value (NAV) where all future interest payments and principal are covered.
The CPDO downgrades, coupled with recent widening in spreads on the CDX IG and iTraxx Europe indexes, have sparked fears of an avalanche of cash-outs leading to increased spread volatility as CPDOs are unwound into an already weak market. Because of their high leverage - up to 15 times - these structures have a heightened sensitivity to changes in credit spread.
CPDOs are based on a portfolio of credit default swaps (CDSs) mainly using the US and European investment grade indexes. They take a leveraged exposure to the underlying synthetic portfolio to meet a target return – either increasing leverage (up to a certain limit) as the portfolio loses value, or decreasing it as the underlying makes money. If the leverage limit is reached, the product starts to lose value; if the NAV of the underlying portfolio drops below the cash-out point, usually 10% of the original value, the structure is unwound and sold off, resulting in a significant loss for investors.
Some CPDOs, mainly referencing financials, have already cashed out. The Tyger CPDO arranged by UBS, with €47.5 million in principal, unravelled in November last year, after a drop to 10% of NAV forced the fund to sell its holdings. “Considering the volatility and credit spreads in the last six months were mostly felt in the financial sector, it is not a real surprise that the financial-only CPDOs would be particularly badly affected,” one market participant commented.
However, it might be too soon to write off CPDOs altogether. According to the London-based research company Creditsights, the risk of more cash-outs is remote. David Watts, an analyst with the company, wrote in a report earlier this year: “We do not believe that either has [caused] large-scale unwinds in CPDO portfolios.”
In addition, credit spreads would have to reach considerably higher levels to cause massive unwinds in these structures. “Despite NAVs on the worst-performing CPDOs falling as low as 40% of principal, we believe the risk of cash-outs is somewhat remote, with the first not likely occurring until the average spreads on the CDX and iTraxx reach roughly 200 basis points,” explained Watts. “As a rule of thumb, the average spread on iTraxx and CDX indexes needs to widen by 16bp for a 10% fall in NAV, assuming the CPDO is running at maximum leverage,” he added. As of April 9, the five-year CDX IG index was at 101.7 basis points and the five-year iTraxx Europe at 102.1 basis points.
“We would agree with Creditsights on their report," said one market participant. “Of course it has been a sort of rocky ride along the way, but, especially with the spreads coming back in, CPDOs have managed to pull back from those trigger levels because they have a lot more cushion now.” He added that the structures have proved fairly resilient to mark–to–market volatility.
“My personal opinion is that the rating agencies have been super conservative in their ratings of all these structures in the last three to six months, because they have a lot of political pressure to do so,” he said. This raises the prospect of upgrades on previously downgraded CPDOs in the future.
In the meantime, some participants have decided to follow a more hands-on approach in their management of these structures, to prevent further deterioration. The UBS-arranged Elm series 104 and 106 CPDOs restructured and injected new capital last year.
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