CDOs with equity puts emerge in Asia

JP Morgan Chase has begun marketing synthetic collateralised debt obligations (CDOs) with embedded equity put options to a small number of investors in Asia-Pacific. The structure is aimed at sidestepping the sometimes-thorny issue of determining whether a credit event has occurred, as well as bolstering returns for investors.

“One of the problems with [synthetic CDOs] is whether there has been an event of default and what the recovery rate is going to be,” says Bart Broadman, Japan chairman and head of credit and rates, Asia-Pacific, in Tokyo. “By embedding equity derivatives into the credit structures, you can very cleanly trigger the knock-out of a particular name.”

The concept behind the product is that if there is a default on any name within the synthetic CDO, the stock price of that company will probably fall, triggering the equity put option in the structure. This resolves the controversy surrounding the definition of default and the issue of restructuring, explains Broadman. “This structure can make it easier to monitor the credit event and make the outcome post-event less subject to debate, restructuring, credit committees and so on,” he says.

The CDO also offers a greater return to investors by making a relative value play between the equity option and the credit default swaps within the structure, adds Mahesh Bulchandani, managing director of Asian structured credit products, based in Tokyo. “If you model the volatility of the equity puts to get the implied credit spread, and compare that to the observed credit spread, you often find that the observed credit spread is actually too tight and there is potentially a relative value trade between the equity market and the credit market,” he says. “This can be captured by including the equity put trigger into the CDO structure.” The return for the investor can be as much as double the return on a traditional synthetic CDO deal, Bulchandani adds.

The structure is in the early stages of marketing, but the bank is confident the product will appeal to Asian investors looking for enhanced returns, says Broadman. “The big opportunity seems to be around how to do the CDO type structure better, smarter, faster,” he adds.