BofA highlights danger of over-leveraged synthetics

While accepting that relatively low subordination and defaults by so-called 'fallen angels' had a negative impact, the US bank’s research found that early investment grade synthetic CDOs’ leverage also contributed to poor performance.

Cash investment grade corporate CDOs typically have around 5% equity, but some synthetics were structured with as little as 1% required for equity deposits, said Lang Gibson, New-York based director of structured credit products research at Bank of America.

The significant ratings migration witnessed on notes issued by some of these synthetics has led to most recent investment grade synthetic CDOs being created with substantially less leverage, he added. Bank of America'a research found that CDOs' referencing underlyings other than investment-grade corporates were not over-leveraged.

Against the backdrop of increased defaults, investors have demanded that structures offer better protection. For example, there is increased diversification in investment grade synthetics that are now coming to the market, claims Gibson in a research note Addressing CDO downgrades and evaluating rating methodology.

So whereas 100-name portfolios have historically had a diversity score of less than 50, some recent deals have hit the market with scores of around 150 – indicating much greater diversification. Diversity score is a measure of default correlation risk, which is related to the diversification of the portfolio.