The first-generation CPDOs were exclusively static portfolios of index exposures, comprising of equal measures of CDX and iTraxx credit default swaps. In the managed versions, the index component of the portfolios was combined with some single-name credit default swaps. In this deal, the portfolio is exclusively made up of 100 names, and has a lower rating limit of Baa2, after which the manager has one month to substitute the downgraded names out of the portfolio. Within the 100 names, there is a 15% bucket for emerging market non sovereign CDS, a new innovation for a CPDO portfolio.
“With the lower rating limit in the portfolio, we feel that the emerging market bucket offers a high quality of eligible credits, with a very attractive spread pickup on a risk reward basis,” said Ulrich Willeitner, deal captain of Alhambra at Deutsche Asset Management in Frankfurt.
The bucket is restricted to names from certain countries approved by Moody’s, and will initially be invested at 8% of the portfolio notional.
“The emerging market bucket is restricted to non-sovereign names from specific countries that were proposed by the manager,” said Michael Mueller-Heumann, associate vice-president at Moody’s in London. “We looked at historical spread data on names from those countries and satisfied that our assumptions about the link between spread and rating remained valid stressed our spread assumptions to capture the higher volatility we saw in those spreads.”
In addition, there is a 20% bucket for outright short positions, which is initially unused. “The short bucket will be used for outright short positions,” said Willeitner. “The short facility will be used opportunistically rather than systematically where we see value in individual names.”
Notes were issued in euros and dollars, with tranches rated at Aaa and Aa2. The former tranches offered coupons of 90bp over benchmark, with 150bp offered for the latter. Leverage over the first two years is limited to five times for the highest rated notes and six times for the Aa2 rated tranches. After that point, leverage can increase incrementally over the life of the ten-year notes, reaching a possible limit of 20 times shortly before the target cash in date of 7.5 years.
The principles that apply to CPDOs still apply to the leverage mechanics, as the market value of the portfolio gets hit, leverage can increase in order to recoup those losses. Unlike index-based structured products, there is no roll cost associated with the ramping up of exposure. The portfolio guidelines also mean a slightly different form of risk in terms of default probability and severity.
“In this product there is a higher rating threshold and less time to replace names that have dropped out of the portfolio, when compared to the index based CDO,” said Gareth Levington, managing director at Moody’s in London. “That results in a higher number of smaller losses, as it is comparatively more likely to drop out, which makes for a reduced volatility of the losses.”