Financials first CPDOs to crumble

The spotlight is on the constant-proportion debt obligation (CPDO) market after widening credit spreads forced UBS to restructure several tranches of its Tyger financial CPDO, which is based on bespoke portfolios of credit default swaps.

The UBS Tyger notes, issued through special purpose vehicle Elm, differ from the first-generation deals, as they reference a bespoke portfolio. The notes were restructured due to spread widening in the underlying portfolios. “The unwinding that we have seen on the products that reference the financial sector has been abnormal,” said Olivier Toutain, a senior credit officer at Moody’s in Paris.

UBS was forced to cancel a portion of notes in one series of the notes and restructure the notes to provide additional notional to two others. This has led to a reduction in the leverage amount, given the increased noteholding portion. UBS was also forced to buy back €5 million of notes from another series, leaving €47.5 million of notes in the series, which has been downgraded from Aaa to Aa3. Several of the series will suffer from reduced coupons as a result.

The recent volatility in the credit indexes, and across the credit market as a whole, has led to concern among market participants regarding the performance of the latest products to be issued. “What you must bear in mind is, where a product is at maximum leverage for the first two or three years, and the underlying indexes widen, there is no possibility to increase the leverage further,” said Toutain. “That means no possibility to lock in higher spreads and performance will be affected.”

The first CPDO, called Surf CPDO, was issued by ABN Amro in July last year. Over the next twelve months many other banks followed suit. The first generation of products referenced the CDX and iTraxx main credit indexes in equal measure, although bespoke portfolios managed to various degrees also emerged in the ensuing months.

The Surf product offered a rated coupon, based on the 15 times maximum leverage available in the structure. The mechanical leverage algorithm allowed the leverage to be increased as spreads widened and reduced the net asset value (NAV) of the structures. Embedded in the structure was a cash-out point - a minimum level of notional portfolio value - at which there is enough capital in the structure to pay all future liabilities. Once that point is hit, the product sells its exposure to the indexes and reinvests in safe assets, such as zero coupon bonds. (As yet, there is no talk of Tyger - or any other financial CDOs - hitting the cash-out point, which is 10% initial NAV in Tyger's case.)

In the longer term, the pressure could be lifted by the advent of so-called managed lite transactions, sometimes called second-generation CPDOs. In these structures, the starting leverage is much lower, typically 7.5 to 8, and the leverage limit increases or decreases depending on the weighted average spread of the underlying indexes. Rather than simply depending on the mean reversion of spreads and an increase in leverage to counteract losses, the structure has the room to increase exposure in a widening environment.

“The variable leverage structure was created at a time of very low spreads in the underlying indexes, and was a way of betting on future spread widening,” said Toutain. By contrast, recent CPDOs include embedded long/short strategies, which can also have a significant advantage in spread-widening environments. However, it remains to be seen whether these short facilities have been used to stem the effect of the financial crisis.

See also: Barclays Capital launches managed bespoke CPDO
CPDO ratings criticised by Derivative Fitch
CPDOs - A true sense of proportion