Structured credit: who needs a psychoanalyst?

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No wonder that every investor, manager and investment banker involved in structured credit has been struggling in the recent past to analyse the market trends and assess what's next. This strategic analysis was made even more necessary by the credit spread environment that reached all-time lows (e.g. US CLO triple - As printed at 25 over Libor) and was just another reason to depress the morale of most of market participants.

Analysing the key trends of the structured credit market is one option available to avoid lying down on the sofa with a psychoanalyst.

- Managed synthetics

- Market value synthetics - credit CPPI

Multi-asset class managed synthetics

In 2004, a few managed synthetic CDO deals hit the market: Ocelot (managed by Prudential M&G) and Aria (Axa IM) became the benchmark deals, foundations of this new market.

Since the beginning of 2005, an increasing number of managed synthetics have been arranged and distributed (with various degrees of success). A leading structured credit arranger should by now be able to offer managed synthetic deals on almost every asset-class (investment grade to high-yield corporate, CDOs-squared, ABS, loans, emerging markets). For example, Calyon is currently marketing the following managed synthetic transactions on different asset classes:

- Corporate High Yield - BISHOPSGATE, managed by Stanfield Capital Partners

- Corporate CDO-Squared - MIDGARD, managed by Henderson Global Investors

- Corporate Investment Grade - SELECTA, managed by Credit Agricole Asset Management (CAAM)

The emergence of high-yield managed synthetics is driven by the lack of supply of leveraged loans deals: managed synthetics deals are filling this gap, since most investors are keen to invest in CLOs (as reflected by the tight spreads seen on recent deals). In addition, the flexibility offered by synthetic structures allows investors to benefit from specific features, such as fixed recovery on high-yield names which turn these high-yield managed synthetics deals into CLO look-alike.

Market value synthetics: credit CPPI

The concept of market value CDOs is not new. Some of the first cash CDO deals closed in the early 1990s were indeed market value transactions. Recently the concept has been successfully applied to synthetic CDOs, which reference primarily portfolios of credit indices.

A market value synthetic structure is quite similar to what is commonly called CPPI (constant proportion portfolio insurance), and therefore was dubbed 'credit CPPI'. An example of this new structure is CREDIT SAIL, a credit CPPI launched by Calyon in the last quarter of 2004. This product allows investors to benefit from "leverage with control": CREDIT SAIL references a portfolio of credit indices with a nominal equivalent to several times the amount invested by investors. Every day, the leveraged credit portfolio is stressed, according to specific market parameters (such as credit spread widening, default rate on the portfolio and shift of interest rates) in order to assess whether the size of the credit portfolio should be adjusted up or down.

Credit CPPI performance is path-dependent and the expected return should be analysed considering different scenarios (spread volatility, default rate and interest rate volatility). Monte Carlo simulations can show that the average return of a 10-year CREDIT SAIL referenced to mixed portfolio of credit indices (CDX NA 45%, iTraxx Europe 45%, Crossover 10%) can on average achieve a return over 300bp over Euribor, while still offering 100% capital protection. This explains the strong investor demand for credit CPPIs in 2005 such as CREDIT SAIL.

The current complexity of the structured credit market makes it both challenging and quite attractive. Psychoanalysis might only be required by those repeatedly complaining about the tight spread environment that strongly minimises usual arbitrage opportunities seen in 2002-2003. The others will see this difficult market environment as an opportunity to differentiate one from the competition with innovative structures.

Loic Fery, Managing Director, Global Head of Structured Credit Trading - Structuring - Sales

Calyon

Tel: +44 (0) 207 214 6643

Email: [email protected]

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