A versatile instrument

CPPI

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Credit CPPI - or to give it its full title, constant proportion portfolio insurance - has come a long way since the inaugural transaction in December 2003. Yet already the budding structure - a form of dynamic hedging which offers protection on the principal at maturity, while investing the present value of the interest in leveraged strategies - is rapidly taking root in the global market. Development of CPPI is focused mainly in the European market, though other regional hotspots include the Middle East, Asia and Australia. Thus far the US may have shunned widespread investment in CPPI due to cost, compliance and education factors, but bankers forecast growing interest from the region this year.

It is hard to ignore the product's advantages, which lie predominantly in the versatility and flexibility of the structure's framework, which can be tailored to specific tolerances of risk and a wide range of investment strategies. In the world of credit, CPPI products have referenced the risk of the CDX and iTraxx credit default swap indices, managed bespoke collateralised debt obligation (CDO) tranches, constant maturity credit default swaps and long/short credit arbitrage strategies.

The growth and increase in liquidity of the iTraxx and CDX indices are boosting demand for CPPI and its structuring capabilities for market participants. Many now see it as an alternative to direct investment in the single- or multi-name markets, says Domenico Picone, head of structured credit research at Dresdner Kleinwort Wasserstein in London. He reports seeing more credit CPPI products being printed for various classes of investors, some not previously involved in credit, such as retail participants. "This evolution indicates the wide applicability of credit CPPI and the flexibility of the framework," he says.

Ally Chow, head of structured credit product management and syndicate at Calyon, believes that more and more investors are comfortable investing in CPPI transactions. "The market's development is on the same track as the synthetic CDO market when it first developed," she says. First-generation products are being used to "educate investors and make sure they feel at ease with the structure and understand the underlying risks".

A host of products in the market have been constructed with long credit exposure to take advantage of the tightening in credit spreads over the course of the last three years. But now, say bankers, there is a growing number of end investors requesting products that provide security against spread widening.

Adam Dixon, head of the German and Austrian derivatives marketing team for credit products at JPMorgan, notes that investors are starting to question when the credit cycle will turn after seeing a gentle rise in idiosyncratic events in the last nine months. He forecasts 2006 to be a range-trading environment punctuated by idiosyncratic events driven by LBO and M&A activity, and 2007 to see spreads on a more widening trend. This will further strengthen the argument for CPPI. "CPPI products lend themselves very well to moving into a different phase of the credit cycle where spreads are going to widen more generally," says Dixon.

The Paris-based head of fixed income and credit at Credit Agricole Asset Management (CAAM), Jean-Franaois Boulier, says that the firm's clients have been disappointed that the strong rally in the credit market has resulted in meagre spreads on plain vanilla credit. "Clients want new ways to invest in credit to ensure yield and return. CPPI has come at the right time and though it may not be a product for every occasion, it is very appealing for the current market condition," he says.

From static to managed

A recent trend in the market is the move away from static long-only strategies to managed transactions combining long/short strategies. Here, a manager seeks to optimise returns by dynamically rebalancing the portfolio between the risky and risk-free assets and adjusting leverage on market moves. This kind of strategy is heavily dependent on the capabilities of the manager and optimising a manager's experience and track record in generating outperformance.

"The alpha that is leveraged can be from a manager's stable long-term capabilities of managing a certain portfolio of names that they benchmark or it could be from the hedge fund-type approach of managing long/short tranches of credit or even correlation risk," says JPMorgan's Dixon. "If managers consistently generate 30bp outperformance, we can put together a product using derivatives taking their name-picking ability, stripping out the benchmark component and leveraging that alpha such that it yields an attractive risk/return profile."

Adds Gunnar Regier, JPMorgan's Frankfurt-based co-head of fixed-income sales for Germany and Austria: "Rather than moving down the risk spectrum or credit rating, you are looking for a consistently safe and predictable rate of returns, which you then leverage. This is a more comfortable position than an idiosyncratic, high-risk/low-rating environment for many investors, especially when combined with principal protection. Because the relative-value aspects of a trade can be quite small, applying a degree of leverage is the only way you can make these positions more significant in value for the investor."

A number of private transactions have been conducted on a reverse enquiry basis, whereby a client comes to a bank and requests a certain structure privately. But bankers say that the public transactions are more efficient than bilateral trades. There are, however, some specific features of bilateral trades which compensate for automated and rules-based management. Having a manager on board promotes better economies of scale, as a manager is able to undertake the daily risk management of the portfolio. Didier Campant, senior credit derivatives structurer at BNP Paribas in London, believes that active management also helps to mitigate default, mark-to-market and idiosyncratic risk. "You need managers that are able to generate alpha no matter what the market conditions and use both long/short or multi-strategies," he says.

The inaugural European credit CPPI transaction was a $50 million deal issued by ABN Amro and launched in 2003, snappily titled Eurozone Inflation-Protected Series 1 Dynamic Participation Notes. Another breakthrough deal was last year's BNP Paribas-arranged Dynamo transaction, managed by Credit Agricole Asset Management. One of the first transactions to propose a dynamic use of leverage, Dynamo is a whopping $800 million deal, split into two series of notes: a EUR525 million tranche and a second offering in various currencies, such as US dollars, euro, sterling, Swiss francs, Japanese yen and Singapore dollars.

"We just added another element onto our investment process and that is the amount of leverage we can put on the portfolio of cash bonds and credit derivatives," says CAAM's Boulier. "The dynamically managed product will help combat the rise in event risk and any change in the credit cycle. In addition, interest rate risk is hedged out, which provides more appeal in the present situation with rising short-term interest rates."

Since the Dynamo transaction, the market has witnessed a mass of deals showing similar characteristics from a host of other institutions. One fund manager that is leading the charge is Axa Investment Managers, which closed its Keolis transaction in April. Arranged by Societe Generale, Keolis is expected to raise EUR500 million and provide Axa IM with a higher degree of flexibility in its application of leverage to trading strategies.

Leverage is dynamic and dependent on Axa IM's views on the riskiness of the underlying strategy, i.e. a more risky one would decrease leverage, while a less risky strategy increases leverage. The transaction also offers low spread risk characteristics, targeting a beta (correlation with the broad credit market) close to zero, says David Benarous, portfolio manager of Axa's hedge funds group in Paris. "The transaction gives investors a diversified carry proposition and no systemic exposure to the credit markets," he says.

Keolis takes a risk-based approach similar to a hedge fund-type framework and does not play the directionality of the market. Benarous explains that the fund is able to leverage its positions on second-order credit risk, such as the slope in the credit spread curve and correlation, in addition to idiosyncratic and dispersion risk, to achieve its target returns.

The structure is put together using a gap value-at-risk (GVAR) framework that takes into account risks embedded in the strategies undertaken by Axa IM and calculates the potential loss of each scenario. "This is for all components of credit: default, spread and correlation risk," says the head of Societe Generale's structured credit group, Hubert le Liepvre. "We created a framework where the manager could implement views and change them according to the prevailing current spread environment, which is an ideal world for investors."

The GVAR framework has enabled Societe Generale to come up with a methodology that defines the leverage ratio for each strategy designated by Axa IM. The fund manager will use only up to 70% of the leverage; the remainder will act as a buffer to absorb market moves. "It is very transparent, the manager has the tools to express his views and the investor is able to see the levels of leverage consumption," says Le Liepvre.

Axa IM also has another actively managed deal in the market called Ocean which, in a similar vein to Keolis, provides the manager with a flexible approach to generating alpha, explains Calyon's Chow. Ocean is a market value structure and through daily risk management Axa IM has the ability to rebalance the portfolio within prescribed risk budgets when the need arises. The structure has long and/or short exposure to single-name credit default swaps, cash bonds and indices.

"The use of these highly liquid derivative instruments allows the manager to enter and exit trades more efficiently due to tighter bid/offer prices," says Chow. "We do not include tranches in the Ocean portfolio which is designed to appeal to the widest possible investor base; with tranches, the risk profile would be different and we believe that only investors who are comfortable with correlation risk in the structure would appreciate tranches in CPPI structures."

Referencing iTraxx

Elsewhere in the market, JPMorgan has teamed up with Landesbank Baden-Wurttemberg (LBBW) to launch a credit CPPI product for the German bank's domestic client base which references standardised tranches of the iTraxx index but does not actively manage the single-name risk. "It is not a credit pick; the only credit decision is referencing the iTraxx," says JPMorgan's Regier. The LBBW trade is constructed by using the JPMorgan-termed synthetic portfolio insurance for principal protection. The LBBW strategy aims to avoid spread and correlation risk, and to a certain extent default risk. "We can quantitatively evaluate the tranches and apply principal protection and provide leverage to a degree where we feel comfortable," he adds.

Another area of CPPI that is evolving is the underlying asset class. A number of products have been launched referencing the performance of funds. At the end of 2005, Australian asset manager Absolute Capital launched an instrument called Packaged Income Notes based on a fund of credit funds. The instrument is exposed to funds from a wide range of managers, diversified by region, investment strategy and underlying assets.

In addition, Spanish bank BBVA has introduced CPPIs based on mutual funds and credit portfolios, raising EUR700 million last year, says Juan Blasco, Madrid-based head of credit trading. "We found a niche in the market where investors were looking to capture leverage and get their principal protected until maturity," he says. The transactions are structured according to a fixed algorithm, so customers can know in advance the maximum leverage factor, drop-down permitted, investment in the underlying asset, etc. Insurance companies, pension funds and financial institutions such as savings and private banks across Spain, France, Italy and Portugal have been quick to buy into the product, adds Juan Garat, head of credit sales at BBVA.

The bank's first series of fund-based CPPIs were not exposed to total-return funds or interest rates, though the success of these products has led to BBVA introducing more credit-based funds this year using an array of fixed-income, total-return funds and other assets in the structure. By the middle of February, BBVA's sales desk had seen EUR60 million of interest. At the time of press, BBVA was working on a liquid benchmark trade.

Garat explains that the relatively conservative nature of the client base is being reflected in the structuring of the instruments. "We want to make sure investors are comfortable with the underlying so we have stayed away from complex strategies," he says.

The bank does not include anything that is not in its own investment books or that it does not manage, says Blasco. The bank conducts all the due diligence, compliance and risk assessment in-house. "It is more like a partnership between us and clients, who provide us with feedback in asset selection and we provide them with the most efficient asset allocation, the optimal leverage and, of course, the BBVA guarantee of repaying principal," he says.

Other institutions are also joining the CPPI party, such as German bank HVB. "We are thinking about a structure where we are acting as the manager and have certain rules governing the leverage and investment of plain vanilla instruments," says Jochen Felsenheimer, head of credit and credit derivatives strategy in Munich. The bank is currently in the stress-testing phase and has no execution date yet arranged. HVB is also looking at CPPI as an attractive addition to its own investment book.

Houses are continuing to invest in the platform and product to satisfy growing requirements from the investor community. With interest in the CPPI market on an upward curve, maybe the soothsayers are right in promoting CPPI as the year's structured credit favourite.

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