After the storm

Since the turn of the year instability in the structured credit market has intensified as negative news buffets all asset classes. Volatility in the credit derivative indices, unwinds of mezzanine collateralised debt obligations, falling secondary loan prices, concerns over leveraged super-senior tranches and highly levered instruments such as constant proportion debt obligations have further exacerbated a fragile situation.

Uncertainty over the direction of the major economies and how that will influence risk assets will be an important driver of the market in the near term, says Jamie Stuttard, head of structured credit at Schroders in London. He also highlights uncertainty stemming from the rating agencies' re-evaluation of their methodologies and models. "It's been a tough market and has been selling off aggressively. The momentum of cheapening is not necessarily finished if we see further unwinds of highly leveraged instruments," he says.

Many investors are finding it hard to take a fundamental view on the market and thus have no interest in putting new money to work. "This market is currently driven by technicals which are deteriorating faster than we predicted. There is so much volatility and uncertainty that it is hard to forecast what will happen," says Ashish Keyal, director in structured credit/CDO strategy at Lehman Brothers.

The dislocation is prompting investors to scrutinise their holdings, rebalancing portfolios, restructuring transactions and diversifying exposure, say bankers. "We have seen a lot of activity around the restructuring of synthetic CDO deals that investors hold," says Keyal. "2007 was the year of innovation and adding leverage on account of tight spreads. Now, given that spreads are so wide, investors are looking for simplicity and demanding no leverage."

For instance, some banks are advising investors to switch exposure out of consumer credit into corporate credit, remove underperforming sectors like financials and homebuilders, restructure market value triggers and add more subordination to make deals more rating-insensitive.

Domenico Picone, head of structured credit research at Dresdner Kleinwort in London, adds that many investors are now looking at accounting solutions able to protect their structured product investments from the current mark-to-market volatility.

"We are discussing ideas of transforming some embedded derivative transactions into accruing-type products and removing the P&L volatility," he says. Cian O'Carroll, head of structured credit at Fortis Investments in Paris, adds: "A lot of the restructurings are trying to offset the mark to market, stabilise ratings and include a manager to achieve a better-quality portfolio."

Schroders has implemented defensive positions since the middle of 2007 and ensured that short buckets are filled close to the maximum limits permitted across its credit portfolios. Navigator, the firm's actively managed constant proportion portfolio insurance (CPPI) transaction, comprises a short bucket of up to 50% and has been running at over 46% for the entire year. Stuttard adds that the portfolio has also switched between names, taken profits by closing shorts on single names that have widened, such as US homebuilders, and rotated shorts in various cyclical European credits. "We have had stable absolute returns year-to-date due to active management of portfolios and being very defensive on direction," he says.

Finding the gems

Despite the air of caution, Andrew Donaldson, CEO at Credaris, believes the huge overhang of assets in the market still provides an opportunity for those nimble enough to implement risk-taking strategies. "Structured credit is not damaged terminally and has retained a tremendously flexible approach to navigating a major credit dislocation. When markets dislocate so much, a lot of gemstones get tossed out with the ashes and these opportunities can generate tremendous returns if you have the technology to identify them and the people to risk-manage them," he says.

Picone adds that though activity is limited, it is a market for the risk-takers and he envisages further demarcation of the client base. "Those who possess the analytics to scrutinise products will be able to better understand and analyse the mechanics of a deal," he says.

Bankers estimate that there are up to $5 trillion of structured finance assets, about a fifth of which have exposure to the US mortgage markets. And with so many CDOs suffering massive losses, they have become cheap compared with their expected cashflows. Many expect repackaging, restructuring and secondary trading of distressed transactions to occur. What's more, a number of funds have been set up and more are ramping up to take advantage of distressed opportunities and special situations being presented across the CDO, leveraged loan and ABS sectors. Hildene Capital Management is looking to raise up to $1 billion to invest in distressed CDOs, including CLOs, while Carlyle Group and Manulife Financial are also raising distressed funds.

A number of players that have been absent from the market in the last two years due to a tight spread environment are returning and being joined by new entrants in structured credit. "They look at the headline numbers, for instance a five-year triple-A tranche paying in the region of Libor plus 300bp, and feel now is the right time to get involved," says Fortis's O'Carroll. "Also some of the larger sophisticated accounts are in discussions to print mezzanine CDO transactions that include a customised cushion."

The market's dislocation has resulted in the emergence of a saner approach from investment banks in the first weeks of 2008. "Investors are demanding far greater clarity on the underlying risks that a deal or fund is exposed to. There are better-quality product constructions being proposed that look more sensible than earlier structures. This is natural; right now we're seeing interesting evolutions in single-tranche transactions and particularly in CPDO-type structures," says Donaldson at Credaris.

Pockets of activity have centred on trading ideas for short-dated first-to-default baskets across a range of maturities and exposures. Bankers note a one-year basket of German corporates was quoted at 150-200bp and a five-year basket of western European sovereigns at 60-80bp. There is also demand from Asian investors on corporate baskets. Trading activity has been two-way, both in terms of hedging and taking exposure.

Picone says that if investors are more concerned with jump-to-default risk (the risk that a credit defaults before the market has had time to factor its increased default risk into current spreads), it is more cost efficient to buy protection with first-to-defaults on a select basket of names than buying protection on every constituent of a credit portfolio. "FTDs are a cheaper way of hedging counterparty risk, particularly in financial names," he says.

There is also interest in curve steepener trades, particularly for investment-grade financial CDS. As curves have flattened, demand from investors has been evident for constant maturity CDS trades, believing that the credit curve will steepen in the future. Some investors have been trading the five-year versus the 10-year curve and three-year versus five-year. Due to the floating coupon, CMCDS also allows investors to go long with less mark-to-market volatility.

Interest is also growing for investments that are uncorrelated with the economic cycle. Picone says that, though still a niche area, there is burgeoning demand for infrastructure bonds, which are repackagings of utility and PFI/PPP project finance bonds. "We are looking at structuring deals that are relatively less exposed to the US economic cycle and investors see value in long-term projects that provide stable cashflows," he says. Interest is also being generated in insurance ABS and natural catastrophe risk.

Bankers highlight further evolution of synthetic CLOs as liquidity grows in the loan credit derivatives market. Touted as one of the big developments of the year, Picone is not so convinced about the prospects for loan CDS. "Many are looking at the possibilities of accessing the collateral using LCDS and synthetic CLOs are a good idea. However, the time is not right as there are huge concerns about the performance of the loan market and many market value CLOs hitting liquidation triggers," he says.

Who calls the shots?

He also points to continuing documentation issues that need to be resolved before liquidating a CDO when an event of default is triggered. For example, while super-senior investors are defined as the controlling class, the liquidation decision is not always at their discretion. In some deals, two-thirds of each voting class has to agree separately (therefore lower-rated tranche investors also), and occasionally the swap, hedge and CDS counterparties also have to agree to liquidate. Sometimes 100% of the noteholders or controlling class have to agree, in other deals only the majority. The specifics therefore vary from deal to deal.

Bankers note interest for synthetic CLOs from clients and say more institutions will look to launch products into the market this year. Carlyle Group launched Europe's first managed synthetic CLO in December and a number of institutions are also thought to be considering launching transactions, taking advantage of not having to ramp up assets and the ability to customise deals.

Anecdotal evidence suggests that some investors have also inquired about principal protection and options on the ABX, feeling they can extract value from ongoing volatility. Also some accounts with a bearish strategy to credit have taken short positions on several of the indices and then hedged this strategy by using dynamic portfolio insurance. "The client hedged the position by going long with a dynamic strategy to lock in spreads," says Picone.

O'Carroll feels that CPPI transactions that combine principal protection and correlation trades will continue to see interest. Correlation has shown itself to be very attractive in balancing idiosyncratic risk and systemic risk. Implementing a long/short arrangement of tranches to be long correction will be beneficial in a situation of rising systemic risk. When that eventually reverts to a more idiosyncratic situation, trading single names will help to manage the idiosyncratic risk, he explains.

Fortis combined with Calyon to launch two new CPPI products, Whistler I and II, in December last year and will launch further correlation CPPI products shortly. "Principal protection is still very much in vogue and correlation, albeit not a mass market product, has performed very well," he says. "All our outstanding correlation CPPI funds are on or above target numbers with internal rate of returns between 8% and 12%."

Credaris has also been active in the correlation market and launched a new fund in early January. The Credaris Correlation Fund started as a standalone fund with EUR50 million of investment and Donaldson believes a target size of EUR350 million is sensible in these market conditions, particularly given the fact that the correlation programme has a 30-month track record, returned 60% in 2007 and has begun the year positively. "The first investors have stepped in and other discussions are going well. We've had a fantastic two-and-a-half years with this strategy and the first few months as a standalone fund have kept up with the performance record," he says.

Donaldson says Credaris is not just reliant on model-based valuations in its approach to the correlation market. "Top-quality models are essential in this area but you need to recognise that the technical drivers across the different parts of the capital structure are critically important. Once that distribution starts moving, for example because of the need of some players to re-price super-senior tranches or cover risks, you certainly get paid to have your position right," he says.

The strategy of investing in the equity tranche paid dividends last year, when dramatic spread widening combined with correlation rallying as the market perceived a transformation from idiosyncratic to systemic risk. "As risk transferred to the senior parts of the capital structure, we profited from being long correlation and as spreads widened, we profited from being short credit," he says.

Uncertainty will continue in the near term, though Schroders' Stuttard believes that further out, spreads in the stronger credits will ultimately retrace and provide attractive entry points to invest in credit in the future. Though this may not occur until early 2009, investors need to be vigilant as the speed of recovery will be rapid. "Credit spread levels are in the cheapest quintile over the last 30 years and comparable levels in financials versus previous recessions. When we see eventual and genuine signs of recovery further out, there will be a scramble for assets and any long-term cyclical opportunities," he says.