Investors wise up to structured products

As cash bond spreads tightened in 2004, structurers of collateralised debt obligation products have become more innovative in search of yield. Simon Boughey and Alan McNee examine the success of existing products and the rise of new ones

Rising investor acceptance and sophistication has resulted in structured credit products becoming conventional tools for adding yield. The strength of the collateralised debt obligation (CDO) market in 2004 had a marked influence on the cash bond market, forcing spreads to tighten for 29 out of 30 consecutive trading sessions running up to mid-September.

The compressed spread environment has been problematic for structurers, as the expensive levels of underlying assets restricted construction of new deals at the end of 2004.

"The timing of new launches will prove to be an important element in 2005. If spreads widen, we may see many people launching more CDOs, but getting the timing right will be crucial," says Hervé Besnard, BNP Paribas' head of credit derivatives product development.

Structured debt specialists are confident the structured credit market will continue to flourish and innovation will produce investments. "Product development continues to bring about attractive yields. All guns are blazing in the CDO market," says Ian Clague, global head of exotic credit derivatives operations at GFI North America.

Olivier Vigneron, director of integrated credit trading at Deutsche Bank, thinks in a tightening credit spread environment, financial innovation will be essential to generate yield. There are a host of new products, which will ramp up yield for investors in 2005.

Synthetically creative

Michael McLaughlin, global head of structured products and European head of asset securitisation and investment-grade structuring and trading at Bank of America, believes that underlying asset spreads will not widen much in 2005. "I expect to see a continuation of low volatility. If spreads stay tight, dealers will have to get creative," he says.

Many market participants agree synthetics will dominate the market as investors look for both yield and diversification. Tight spreads have made it harder to source underlying assets for CDOs and synthetic CDOs are one solution to overcome this.

Their popularity is evident in 2004 launch figures of about 550 synthetic CDO transactions versus less than 50 cash CDO transactions. Deal sizes are now more liquid, rising to over $200m.

McLaughlin forecasts a rise in the use of asset-backed securities (ABS), particularly synthetic risk, in 2005. Interest is already apparent, reports Greg Lieb, global head of correlation products at Dresdner Kleinwort Wasserstein (DrKW), who saw renewed interest towards the end of last year in using ABS as the underlying asset class.

"To date, most of our transactions have had 95% of the risk in the corporate bucket and 5% in ABS. Now investors are starting to look at doing deals where the risk is entirely in ABS, with no corporate bucket. Investor interest appears to sit in the mezzanine or equity tranches. It's a way of getting diversification from the investors' point of view," he says.

One of the more controversial and untested applications that might come to the fore over the next year is the use of equity default swaps (EDS) and commodity default swaps among the assets of a CDO. In an EDS, the buyer of protection pays a running premium, which is not referenced to Libor, for the duration of the swap. If the stock against which protection is bought loses 50% of its value, then the buyer of protection receives 50% of his notional principal.

So far, there has been little use of equity default swaps in public CDO transactions, though Moody's rated one deal in early 2004.

"I don't see why you shouldn't have publicly-rated EDS deals in 2005, especially if corporate CDS spreads remain tight and at least some investors educate themselves on EDS," says Rishad Ahluwalia, analyst in JPMorgan's global CDO research team based in London.

Richard Whittle, global head of exotic credit derivative trading at ABN Amro is not quite so sure, believing that disinterest from traditional CDO investors will curb the growth of EDS CDOs. "It incorporates too large an element of equity market risk. Most investors need to stay close to credit," he says.

A commodity default swap functions in very much the same way as an EDS, with the obvious difference that it is a commodity against which protection is bought rather than equity. Barclays Capital launched the first collateralised commodity obligation (CCO), named Apollo, in December 2004, giving investors exposure to 100 commodities trigger swaps, based on the prices of base metals, precious metals and energy prices. The product will aid investors in their search for yield as Apollo offers a wider spread than most CDOs currently in the market. Barclays is set to launch further series of CCOs in 2005, but some analysts are unsure whether the new products will be accepted.

There has also been a growing popularity of 'CDOs of CDOs', better known as 'CDO-squared' consisting of a pool of CDOs as the underlying asset, rather than cash bonds or credit defaultswaps (CDSs). As normal CDOs have comparatively attractive yields given their rating levels, deriving the return from CDOs itself increases the yield by creating an extra layer of leverage.

CDOs-squared have existed for the last five years, mainly as cash products, and their relatively extensive use in the second half of 2004 is set for greater exploitation for yield this year. Investors are doubly insulated against single-name default risk. The filter mechanism of the CDO is applied twice, says Richard Whittle, global head of exotic credit derivative trading at ABN Amro. "More name-specific risk is eliminated and investors are exposed mainly to market risk, though in a leveraged form," he says.

Ahluwalia predicts that interest in synthetic CDO-squared transactions is likely to intensify in Europe during 2005, partly a response to tight spreads. "You add leverage by synthetic CDOs- squared, since it is more difficult to do less levered single-tranche CDOs in the current tight spread environment," he says.

Standard & Poor's head of CDOs, Perry Inglis, says that, until recently, CDOs-squared typically involved five inner CDOs of perhaps 100 names each, with between 15 and 50 very highly rated ABS, typically triple-A rated, as part of the CDO-squared itself. A tighter spread environment has seen the number of inner CDOs rise recently. "There has been an increase in the number of inner CDOs to typically around eight or 10," he notes. "This is because the tighter spreads mean that you need a larger portfolio of underlying corporate names on which to leverage. Cross-subordination across the underlying CDOs has also increased in popularity this year."

High yield for the new crop

The CDO market is also likely to focus increasingly on high-yield and emerging market names to boost yield. A new crop of corporate issuance for CDOs is set to emerge, as new issuers enter the low-spread market. "Although the supply of eligible CDO collateral is down, CDO liabilities will adjust downward as well, thereby opening up the arbitrage again," says Bank of America's McLaughlin.

Michael Rosenberg, co-head of global CDOs at UBS, says that high-yield CDOs in 2005 will be "either in cash or synthetic form, but packaged in much more conservative and robust ways than in the past, to give more flexibility and with less leverage". This will allow investors to take pure high-yield credit risk, without also having to accept market risk and interest-rate risk.

Benign default forecasts over the coming year will support the use of high-yield bonds.

The accessibility of payment streams, either from the cash or credit derivative markets, has improved lately due to much greater liquidity in the sector as well. This, in turn, is also a reflection of relatively benign default projections. But some warn this could change rapidly. "When the credit cycle turns, there will be less liquidity," says GFI's Clague.

Allied to the greater use of high-yield names is the rediscovered popularity of emerging market credits. Ahluwalia of JPMorgan believes that if spreads continue tightening, or simply stay at 2004 levels, lure of better returns will boost demand.

"It's an attractive area, and investors are slowly waking up to globalisation and the recent upgrade trends in many developing countries - our counterparts see Russia as an upgrade candidate for 2005," says Ahluwalia.

Alternative options

He also predicts that CDOs may expand into other alternative asset classes, such as hedge funds or private equity. "People are looking at things like first-to-default baskets by sector," he adds.

Investors will still favour managed CDOs over static transactions this year, says Bank of America's McLaughlin. "Growth in the market for managed deals will be driven by investor belief that credit portfolio alpha is achieved by actively managing credit," he says.

Edward Reardon of JPMorgan's CDO research team says that although some investors employ single-tranche CDOs or liquid-tranched indices to take a leveraged view on credit, others are in the CDO space precisely because they want a specialised credit manager to make credit selection and trading decisions.

"We're in a fairly benign default environment presently; so many investors are comfortable taking on greater leverage. But the experience of static investment-grade CDOs between 2000 and 2002 demonstrates that a good manager can add value if they avoid defaults," he says.

In some managed deals, the manager can go short, which may be a useful strategy to generate trading gains.

Pressure on returns

No matter what ingenious engineering is applied to structured debt products to keep the show on the road, investors will have to get used to the fact that rewards will continue to diminish.

"Investors need to realise that the liquidity and complexity premiums have started to go away as the CDO market matures," says Ahluwalia.

BNP Paribas's Besnard agrees, warning that to date the narrowing in liabilities (CDOs) has not been as big as the narrowing in assets (CDS markets). This means that there is a lot of room for lower liabilities. He predicts CDOs will be launched with lower coupons.

Some investors could just drop out of the market. Interestingly, the experts don't think that a particular class of investor will simply fade away, such as hedge funds, but rather those accounts that have been in the market for a long time and have got used to higher returns.

This article first appeared in Credit magazine

Who's buying CDOs

One of the key features of last year has been the entry of new investors into the collateralised debt obligation (CDO) market. It's a trend that expected to continue, as investors seek both yield and diversification and become more familiar with the concept of collateralised debt.

Unwelcome publicity has hit CDOs, such as German Landesbank HSH Nordbank suing Barclays over the management of a CDO. Investors are becoming more sensitive about the independence of collateral managers, say bankers, and are keen to ensure that the managers' interests are not too closely aligned with those of the structuring banks.

But this doesn't seem to have done much damage to investors' confidence in the sector. New types of investors have been piling into the market; these include hedge funds and specialised CDO companies purpose-built to buy all tranches of CDOs, from equity to triple-A, and sell their investors a diversified set of assets.

Bank of America's Michael McLaughlin sees a migration of hedge funds which formerly specialised in convertible bonds. "These firms are increasingly pursuing credit arbitrage strategies, by using CDOs and tranches on credit indexes to take a view on basis risk, correlation and volatility," he says.

Greg Lieb, head of CDO correlation products at DrKW, adds hedge funds have focused on the riskier tranches. "Increased liquidity in the equity and mezzanine is certainly a welcome development and there has been reasonable interbank trading of the intermediate mezzanine - the tranche between equity and senior triple-A tranches," he says.

Non-traditional CDO investors - conventional fixed-income and alternative asset investors - are also joining the fray. "Investors are now more comfortable and familiar with the product, they need to diversify their exposure and pick up yield, and they are finding structures that are tailored to meet their specific investment objectives," says UBS's Mike Rosenberg.

key points

There is expected to be greater use in 2005 of equity default swaps, collateralised commodity obligations and CDOs of CDOs.

High-yield CDOs are expected to be in cash or synthetic form, but packaged more conservatively to enhance flexibility with lower levels of leverage.