In the middle of a conversation about the revival of the synthetic structured credit market, the asset manager breaks off to laugh: "Case in point – I just received an email from one of the big banks, eager to discuss a bespoke tranche of credit with us, mainly derivatives."
The email also highlights a second key point about the market's return: for now at least, the deals are simpler and more standardised than they were in their pre-crisis heyday. In this particular case, as with all the deals closed last year, the structure is static – meaning there is no manager switching in and out of the underlying credit default swaps (CDSs) – and it is based on three thick tranches, all of which will be sold to investors, says the email's recipient, Saul Greenberg, London-based chief risk officer at SCIO Capital.
Despite being widely viewed as a dead market a little over a year ago, issuance of synthetic collateralised debt obligations (CDOs) reached between $15 billion and $20 billion in 2014, according to three dealers, and some are predicting further growth this year to as much as $35 billion. Banks known to be involved to date include Citi – which told Risk in January it had issued $10 billion last year – BNP Paribas, JP Morgan and Morgan Stanley (Risk January 2015).
So, how far can it go? Some asset managers believe 2015 will see the return of dynamic portfolios – a structure that was a rich source of disputes and lawsuits even in the boom years – but argue it can be done carefully and responsibly (Risk August 2005). That step could widen the market's appeal to pension funds and other investors that like to see an active manager at the helm.
One of the biggest features of the pre-crisis market – the single-tranche deal – is not expected to mount a serious comeback, though. These structures saw dealers creating bespoke portfolios, often for a single investor, and then selling narrow slices of the risk, while retaining and managing the rest in so-called correlation trading books, which now attract punitive capital charges (see box, The rise and fall of the single-tranche synthetic CDO).
Compared to the pre-crisis era, the pricing on senior tranches is cheaper than equity tranches. That is something that is very different today
"The single-tranche business, where dealers were selling or buying protection on a limited portion of the capital structure, is not a viable business any more from a capital charge standpoint," says Denis Gardrat, London-based European head of credit structuring at BNP Paribas.
Rather, new life in synthetic CDOs is coming from deals in which the risk of all the tranches is transferred, with investors acting as protection sellers on tranches of risk and buyers of protection on all the names in the underlying portfolios. These full-capital structure deals remove the need for banks to model and manage the residual exposures created in correlation trading – all of the risk is taken and priced by the market.
According to dealers and investors, today's synthetic CDOs are more standardised and vanilla than crisis-era products. Most feature two or three wide tranches. Crucially, the first-loss piece of the deal – the equity tranche – is thicker, covering at least the first 7% of losses on the pool, compared to crisis-era deals that had equity detachments at 3%. In theory, that means investors in the mezzanine and senior tranches can sleep easier.
Examples of standard detachment points provided by dealers are 10% for equity, with mezzanine now typically detaching at 15% or 30%, leaving senior tranches with the rest. Maturities tend to be shorter as well – three to five years, compared with seven to 10 years in earlier deals.
Another major difference from crisis-era deals is the absence of external ratings, which were blamed for giving investors a false sense of security. Institutional investors, including insurance companies and pension funds, alongside banks, conducted little of their own analysis and flocked into senior, AAA-rated tranches, creating the conditions for a market-wide liquidity freeze when rating agencies started issuing mass downgrades in 2007.
The concept of leveraged super-senior tranches – in which investors were able to post reduced amounts of margin and could accept losses to walk away from deals rather than top them up – also remains a thing of the past. Instead, according to participants in new-vintage deals, investors now post initial margin as well as variation margin over the life of the deal, with the former based partly on a counterparty's creditworthiness.
In today's deals, senior tranches have become more attractive. The popularity of equity tranches has improved pricing for senior paper, and investors keen to get involved in lower tranches were willing to allow dealers to shift some of the spread to higher tranches to get the entire structure off the ground, according to two banks.
"I would say in general, compared to the pre-crisis era, the pricing on senior tranches is cheaper than equity tranches. That is something that is very different today, and it's one of the reasons we favour senior and mezzanine tranches over equity," says Sivan Mahadevan, managing director and head of US credit strategy and global credit derivatives strategy at Morgan Stanley.
Examples of full-capital-structure tranche pricing in a Morgan Stanley research note show senior tranches paying from 65 basis points for a tight-spread portfolio to as much as 95bp for a wide-spread portfolio. Citi told Risk in January that 2014 deals priced super-senior tranches with attachment points at 15% at 30-50bp, compared with 5–10bp pre-crisis (see table below).
The need to vamp-up payoffs for senior-tranche investors has contributed to the use of underlying portfolios that are higher yielding than in crisis-era products. One dealer says more than half of the names in its structures overlap with the on-the-run high-yield corporate indexes run by Markit – the Crossover 22 and the CDX High Yield 23 – while about a quarter overlap with the on-the-run investment-grade indexes, IG 23 and iTraxx Main 22. Another dealer said its underlying pools are a similar mix, though with a greater proportion of investment-grade names (see figure 1).
"Portfolios have spreads of around 150bp, which compared with other credit index benchmarks, is pretty wide. One of the reasons behind wider portfolios is to allow sufficient yield to the senior investors," says Gardrat at BNP Paribas.
The pitch to investors is straightforward. At a time of universally low yields, the deals offer a mix of investment-grade and riskier underlying names, but in a tranche with much more subordination than was available in the past. Hedge funds appear to make up a portion of the investor base, and are said to be big players in all parts of the capital structure, though some institutional investors are also said to be looking at the deals.
It is hard to say how the market will fare when rates start rising, but some buy-side firms are making commitments that suggest they are in it for the long haul.
"We are beginning to spend a lot of our time and research budget internally looking at synthetic structured credit. With a tight market like this, you have to use a lot of leverage to get your return," says Manish Valecha, New York-based head of research at hedge fund Gapstow Capital Partners.
"I think you're going to see a new wave of hiring on the buy side and sell side, because even if people want to do more structured credit now, and even if you have managed to convince an insurance company to look at it over the past few years, it turns out they don't even have the resources to do anything in structured credit any more," says Peter Tchir, New York-based managing director of macro strategy at asset management firm Brean Capital.
Managed deals revival
To reach a broader investor base, some participants predict the next step will be a revival of managed deals, and a step up the credit spectrum for the underlying names. All current known deals are static, meaning the portfolios remain the same until the maturity of the deal. In a managed portfolio, a third party is appointed to trade a bespoke portfolio of contracts, usually an asset manager. Contracts can be substituted in and out of the portfolio to achieve the desired risk profile and return.
"To get real money involved, you would need a higher-quality portfolio and an asset manager that is going to protect the interests of the investor. I would expect the next step of this market is a move away from high-yield static portfolios into high-quality managed deals sold to more end-user investors," says John Weiss, London-based co-head of corporate credit at Cheyne Capital.
Putting together a managed synthetic CDO in the post-crisis regulatory environment, however, will be tricky. For the full capital structure to remain sealed and avoid punitive capital charges, investors in every tranche would have to agree to a shift to keep the underlying portfolios aligned. "In a managed synthetic CDO, we feel structural details are quite important, in particular investors and asset manager alignment of interest. Given our track record in corporate credit derivatives, we have been approached by a few dealers and we would be interested, should investor demand pick up. It's just not clear yet who will invest in managed synthetics. My opinion is managed deals may resurface but they will not replace static deals," says Malek Meslemani, London-based partner and senior portfolio manager at Chenavari Investment Managers.
Other market participants are also expecting relatively limited evolution in the market – citing both the obvious stigma attached to synthetic structured credit, as well as new rules facing alternative asset managers, such as the Alternative Investment Fund Managers Directive (AIFMD) in Europe and Form PF in the US.
"If you take AIFMD and other regulatory proposals and you apply their valuation metrics and transparency requirements to structured credit, there will be an impetus towards more standardisation of otherwise non-standard transactions. These transactions are technology that is not going to merely disappear, but under AIFMD the fund manager has very specific obligations and requirements, as well as liability that can arise from errors in valuation among other things, and it is our responsibility to make sure valuations make sense," says SCIO's Greenberg.
In addition, investors are finding other ways to get exposure to credit. Since the crisis, volumes have grown significantly in options on credit indexes, going from around $38 billion net notional in 2012 to $115 billion in 2015 (see figure 2). CDS index options allow investors to buy or sell protection on the index at a given strike spread, but they tend to be short-dated and are not customisable.
"I do think options have taken away some potential growth from tranches, but probably something like 25%. However, options liquidity usually goes three to four months, and when investors take views they often want longer-dated views. Second, it's still very ‘cookie-cutter'. If there is an index containing names investors are not comfortable with, you can get a cleaner portfolio by using bespoke portfolios. So some investors are willing to sacrifice liquidity to get the names they want," says the head of structured credit at a US bank.
The rise and fall of the single-tranche synthetic CDO
In essence, synthetic collateralised debt obligations (CDOs) of all stripes do exactly the same thing – allow investors to bet on the likelihood of defaults in a portfolio of credit default swaps (CDSs). The exposure arising from the CDS portfolio is tranched so investors can buy or sell protection on a specific slice of exposure – the first wave of losses, the chance of a credit catastrophe, or anything in between.
The crisis-era version of the products saw dealers putting together custom portfolios for investors that wanted exposure to specific sectors, often with quite narrow tranches. This was called correlation trading, because the associated risks were heavily dependent on the degree of correlation among the pool's constituents. The rest of the risk was wholly or partly retained in banks' correlation trading portfolios and hedged using either single-name default swaps or tranches on credit indexes (Risk December 2014).
The resulting risks were poorly understood, and regulators have since applied much heavier capital charges for correlation trading, in the form of the comprehensive risk measure (CRM) (Risk October 2012). This regulation forces banks to model capital charges for correlation trading risks as well as using a standardised measure. If the internal model yields capital charges that are less than 8% of those from the standardised model, the bank must instead hold capital equivalent to that amount – an example of the kind of standardised floor that regulators are now keen to roll out more widely.
The CRM has resulted in many banks winding down their correlation trading businesses, with a few banks – such as Crédit Agricole – shedding the risk en masse while others have allowed transactions to run down and expire (Risk December 2014, and Risk January 2015).
Tranches of on-the-run CDS indexes have been relaunched in recent years, with the iTraxx Crossover series 22 tranches hitting the market last October, though liquidity in tranches on new indexes remains much lower than those on legacy indexes, which are used to hedge the last of the pre-crisis-vintage CDOs that remain on the books (see table).
Market participants say banks have engaged in some bespoke tranche activity since 2011 – mostly to reduce legacy risk rather than creating new, customised tranches. Activity has focused on equity and low mezzanine tranches, as dealers had bought a lot of protection via higher AAA-rated tranches before the crisis, and have since been trying to fill in the capital structure by buying protection in more junior parts of the structure. Tranches on legacy indexes – the typical hedge for these deals – are now rolling off.
Meanwhile, activity in new bespoke tranches is limited, as transactions have to generate a healthy return on much higher capital requirements. In addition, the lack of liquidity in tranches for on-the-run indexes makes hedging more difficult. Finally, interest among investors that still have strong memories from the crisis is limited.
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