London-based investment manager Solent Capital has completed an innovative multi-maturity collateralised debt obligation (CDO), designed to enable it to manage future credit spread widening. The deal, called Waypoint, was priced in mid-March, with tranches denominated in euros, dollars and yen.
"This CDO is only one step away from a plain vanilla investment-grade CDO, but it's an important step," says Nicholas Christen, head of CDO structuring, credit derivatives, at BNP Paribas in London. BNP Paribas was the underwriter of the deal.
The EUR260 million-equivalent synthetic transaction is partially funded, features assets in three maturity buckets and comprises a portfolio of investment-grade credit default swaps.
"The key idea is that the deal is partially invested on day one," says Ray O'Leary, a partner at Solent Capital in London. "Investors are locking in today's levels to some extent, but a portion of the portfolio will be invested later when spreads are wider, which creates a blended or weighted average return from two or more market scenarios."
Waypoint is structured so that the underlying assets have different maturities, rather than the liabilities. The assets fall into three maturity buckets: four years, six years and eight years. Using this structure, Solent has the flexibility to extend and shorten maturities on assets, thereby taking a view not only on a credit's risk but also on the shape of the credit curve. The deal has a maturity of eight years.
The structure could be used to take a defensive position if, for example, an eight-year credit exposure suddenly has more risk resulting from a leveraged buyout threat. In that case, Solent could replace it with a shorter-dated asset. The manager can also choose to extend an asset's maturity to take advantage of spread widening.
"Multi-maturity is likely to become a standard feature in synthetic CDO transactions. If you're a CDO manager, why would you not want the flexibility to not only pick the assets you put in the portfolio, but also to decide the maturity?," asks BNP Paribas' Christen.
"Managers such as Solent are not only looking at fundamental credit quality, but the shape of the credit curve to identify the optimal maturity in which to take exposure to a particular credit," Christen adds.
Other CDO managers have sought to protect their deals from spread widening by including short buckets in their CDO structures. With Waypoint, Solent takes a different approach to the same issue.
"We've come at it from another angle by not fully investing the exposure on day one, and take advantage of that full investment at a later date when the market is potentially wider," explains O'Leary. "We've got a transaction here that benefits from spread widening, which is the same result as having a short bucket, but we've come at it from a different angle. The timing doesn't need to be quite so precise under our structure."
The coupon for the back end of the deal - the final four years - is variable, allowing investors to benefit from any outperformance achieved by extending the duration of the assets in the underlying portfolio.