The new breed

Asian institutional investors are showing increased interest in a new breed of structured credit products such as collateralised commodity obligations and collateralised foreign exchange obligations. Alice Hales reports

The combination of narrow credit spreads and a relative scarcity of traditional fixed-income instruments in Asia to underpin collateralised debt obligations (CDOs) is forcing the region's institutional investors to look at alternative asset classes. And dealers, sensing an opportunity, have started offering new types of structured credit products, including collateralised commodity obligations (CCOs), collateralised foreign exchange obligations (CFXOs) and credit hybrid obligations (CHOs).

Issuance of the new breed has so far been modest; reflecting perhaps some initial conservatism from investors and the need to iron out structural kinks, such as rating agency methodology. But the long-term prospects look promising.

"Both CCOs and CFXOs are likely to appeal as a diversification play," says Rachel Hardee, Hong Kong-based Asia-Pacific head at Derivative Fitch, the derivatives analysis and research arm of Fitch Ratings. "They give CDO investors who currently buy deals backed by corporate credits an opportunity to take on exposure to different assets." Hardee adds that Asian investors are keen to access commodity risk via CDOs, but the business is still bespoke. Fitch rated the first long-short CCO (see Asia Risk May 2007, page 4) and other transactions are in the pipeline.

"As for more innovative products, such as CFXOs, we have received a number of proposals from banks that are essentially variations on this theme," says Hardee. "However, things are still at the exploratory stage. So in the short-term, it is unlikely we will see a flood of CFXO-type deals."

While underlyings such as commodities and foreign exchange might be unfamiliar to many investors, dealers' use of CDO technology to structure the new offerings appeals to buyers. "The general approach is to structure deals in a way that is familiar to credit investors," says Gunnar Hoest, director of fixed income at Credit Suisse in Hong Kong. "There is ongoing dialogue involving banks, investors and rating agencies on the best way to package and analyse risks on these products, which use CDO and constant proportion portfolio technology."

Hoest was involved on Credit Suisse's $190 million Cargo 2 transaction in April, the first long-short CCO, which referenced 100 long and 100 short commodity trigger swaps tied to energy and metals underlyings. Asian investors bought 30% of the paper.

"These products are emerging due largely to the quest for yield and diversification from investors," adds Hoest. "There is a shortage of traditional credit assets offering interesting returns, so investors seek new ways to generate yield in their portfolios. It is still an educational process, but gradually we are seeing rising interest from a broad range of investors, including banks, insurance companies and corporates."

An added bonus of the new products - at least, when the underlyings are commodities or foreign exchange - is that, historically, they are unaffected by what is happening in the credit markets. "They really make sense as diversification away from vanilla products and traditional asset-backed securities, particularly because there is low correlation between commodities and FX and corporate credits," says Anirbarn Lahiri, head of CDO and credit structuring for Asia excluding Japan at Deutsche Bank in Hong Kong. "CCOs and CFXOs are alternatives that allow investors to gain an exposure to FX and commodities yet with fixed-income-type returns."

For some investors, the lack of historical data for what are relatively new structures might be a concern. Lahiri, however, says this is mitigated by the information available on the underlying assets. "The beauty of rating agency methodology is that it is consistent from one product to another: a triple-A rating for any transaction is a positive demonstration of the low probability of default," he says. "And, to mitigate concerns on data, we can run simulations of how deals will perform based on the historical data of the underlying assets. Commodity and currency markets have 30-40 years of information - more than the corporate credit market."

But other parties, including the rating agencies, say an AAA rating on a government bond is not the same as an AAA rating on a tranche of a CDO. And the typical difference in spreads between these securities appears to indicate that the market believes an AAA-rated tranche of a CDO is a more risky investment.

Opinion varies as to which of the new products has the most potential for sizeable issuance. Even the most bullish of dealers admit concerns surrounding liquidity and the need for clear rating agency methodology will limit activity in the short-term for CFXOs and CCOs.

Despite this, returns on recent deals look attractive. The three- and five-year tranches on Credit Suisse's Cargo CCO - rated AAA by Fitch - respectively offered 180 basis points and 195bp over Libor. Aside from yield, investors were attracted by the long/short structure, mitigating risk to principal loss as well as mark-to-market movements.

Deutsche Bank's Lahiri says an attractive feature of CCOs is their use of a diverse range of underlyings to create risk-return structures to suit different investors. He does, however, admit there are limits on maturities on the early deals. "Spreads depend on the underlying portfolio. Our strategy is not to include the most volatile underlyings, but concentrate on products such as soya beans, corn and silver, where there is medium correlation between the assets," he says. "For CCOs, it is difficult to go beyond three to five years - we structure a deal based on how long we can hedge."

CFXOs are modelled in a similar way to CCOs. There has been a small flurry of deals in 2007 with Barclays Capital, JP Morgan and Merrill Lynch coming to market. Barclays Capital has conducted a $100 million deal, while Merrill Lynch says it has done one deal out of and expected programme of between EUR500 million ($680 million) and EUR1 billion. JP Morgan is still marketing its transaction and declined to divulge its size.

Yet some argue that the appeal of CFXOs to Asian investors will be limited, saying that rating agency methodology is applicable for G10 currencies at the moment rather than emerging market currencies. That is because G10 currencies are liquid and transparent, and the mean-reversion theory - that prices will eventually revert back towards their mean - applied by rating agencies in their models, is more applicable to G10 currencies. "Structurers are awaiting clearer rating methodologies," says Lahiri. "Until this happens, you will see a case-by-case approach to putting deals together."

With Fitch Ratings earlier this year publishing its rating criteria for both CCOs and CFXOs - allowing participants to closely replicate its analysis with regard to structural risks, charged-asset risk and counterparty risks - the initial teething problems may soon be resolved.

Even so, Hoest says investors have to get comfortable with one key difference between new products and traditional CDOs. "Payouts of the underlying contracts are subject to explicit market risk," he says. "This is not the same as credit events in a credit portfolio, which are structural - rather than market - events.

"Obviously investors need to be aware of the underlying market risk, but this is mitigated by standard credit tools such as long/short portfolios, CPPI (constant proportion portfolio insurance) and CDO tranching," adds Hoest. "The desire for extra protection in the face or the underlying market risk explains the appeal of long/short strategies - investors are not taking a straight bet on the market, but a relative-value view."

But investors do have alternative options. Constant proportion debt obligations (CPDOs) offering Libor plus up to 200bp for AAA-rated tranches have proven popular (see also Asia Risk April 2007, page 22). These instruments, however, drew fire from Derivative Fitch in April, which said that the first generation of static CPDOs did not deserve AAA or AA ratings. The agency said transactions were too sensitive to movements in key risk parameters, such as spread volatility and bid/offer levels. It also said that the lack of historical data for deals with 10-year maturities was a concern, given that the asset class only has a four-year history, all of which has been in relatively benign credit conditions.

Meanwhile, an investment committee at US fixed-income investment company Pimco calculated that there would only have to be spread tightening of 4bp before the combination of coupon and rating could no longer be achieved on early offerings.

Even so, some dealers remain confident about the long-term potential of CPDOs. And much of that optimism is based on the deals being referenced to iTraxx and CDX indexes, which traditional fixed-income investors still understand better than commodities or forex.

Lawrence Seah, head of structured credit products for Asia excluding Japan at JP Morgan in Hong Kong, readily acknowledges the flaws in the static deals, but says investor concerns can be allayed by the inclusion of active portfolio managers. "The first static deals did not have any ability to manage idiosyncratic pricing risks," he says. "They would roll exposure to investment-grade indexes into a new contract every six months, which meant investors were taking credit risk for that time period. But if some credits deteriorated badly during the six-month period before the roll, you could end up with a negative roll cost, which would impact the mark-to-market."

Managed CPDOs

Seah says managed CPDO transactions offer higher flexibility to avoid downside risks, enabling managers to reduce exposures to positions when they need. "We found that a managed deal, which starts with a lower leverage, gives the manager flexibility to lever up and down within certain parameters was better received," he says. "If there is some volatility in the market, for example, a manager can reduce leverage to avoid any negative impact.

"As for the timing of rolling contracts, managed deals have more potential to benefit from market positioning, whereas the rolling point in static deals might happen when credit-pricing anomalies exist," adds Seah. "Managers can skip or delay rolls to prevent the transaction from losing value."

Credit hybrid structures are also not new to Asian investors. While activity was limited when they emerged in 2004 and 2005, some bankers feel the time is ripe for this type of deal to re-emerge. Seah feels the inclusion of equity underlyings would be especially attractive to Asian buyers. "An interesting area to watch out for will be hybrid structures featuring equity default swaps and credit default swaps," he says. "There are good arbitrage opportunities in this space, plus it would be appealing to investors, particularly retail buyers, who are willing to take an equity view."

Seah admits developments in this area are still nascent, but believes the inclusion of equity default swaps - effectively, deep out-of-the money equity barrier options - could be the source of some interesting new products. These CHO products are not new, but legacy CHO structures were long-only instruments. "The new issues potentially offer short credit structures," he adds.

Eric Slighton, head of Asian credit derivatives at Barclays Capital in Hong Kong, has been involved in hybrid deals involving commodities and corporate credits. He believes mixing two separate asset types allows structurers to create a more efficient portfolio. "Investors want products that are non-overlapping, but this has been difficult to achieve, so the new products present an exciting opportunity," he says. "Commodities are anti-correlated with credit - so adding them into a structure can enhance yields while reducing risk.

"The products we brought to market had good yields and performance, even while the commodities market was experiencing a lot of volatility," says Slighton. "The key is to structure in a commodities layer that is conservative in terms of credit ratings, so it is not adversely impacted during periods of volatility."

Slighton says a quick look at comparative spreads between hybrid commodity products and generic synthetic CDOs highlights the attractiveness of hybrid structures. He says hybrids are trading at more than 200bp over benchmark for AA-rated tranches and 65bp for a five-year AAA piece, compared with 100bp for AA-rated notes on traditional CDOs.

In terms of future innovation, Slighton says range-accrual structures will prove popular. "They allow you to take advantage of steep forward curves for credit and manage volatility risk, so we could see new volatility products developing, with dealers actively trading to reduce risk," he says.

In fact, Barclays is already layering tranche range-accrual swaps onto cash CDOs, most recently with its Markov transaction issued at the end of May. The bank included a range-accrual swap based on the standard five-year CDX mezzanine tranche, producing a spread of 280bp over Libor.

The general tightness of spreads in the credit markets is another factor raising the attractiveness of range-accrual tranches. "They offer very good yield opportunities and a different exposure profile," says Slighton. "The major risk is to extreme widening of credit spreads or disruption to the tranche markets, but, generally, these swaps perform well in bullish, stable or moderately bearish markets."