Managed synthetic CDOs to grow rapidly in 2003, says Fitch

Global growth of managed synthetic deals has been driven by investors seeking to benefit from the active management of the portfolio, the trading expertise of an asset manager, and potentially more attractive prices and liquidity in the credit default swaps market, said the report.

Fitch said 20% of its total deals in the pipeline are managed synthetics, with 80% static. This compares with less than 5% of its future dealflow being managed synthetics this time last year.

Fitch said an increasing number of managers are prepared to use their experience in the credit derivatives market to manage synthetic CDOs by exploiting arbitrage opportunities that exist between credit default swaps and cash bonds. The significant arbitrage opportunities in some of these CDOs have also enabled CDO arrangers to build-in excess spread mechanisms that benefit investors while continuing to offer managers the return they expect.

Fitch believes that as the credit derivatives market continues to expand, a multitude of diverse structures will develop, with standardisation not expected in the immediate future.

Managed synthetic CDOs are similar to static synthetic CDOs, with the exception that the reference portfolio of credit derivatives is traded by an asset manager who may charge ongoing management fees. Proponents of managed structures argue that static CDOs are not well diversified and, therefore, are vulnerable to both company-specific and market risk. The other criticism has been the inability of transactions to take losses early where credit deterioration and eventual default are considered inevitable.

But advocates of static structures maintain that investment-grade structures have successfully eliminated all company-specific risk through diversification. This makes it difficult for the asset manager to add value, since market risk cannot be eliminated and, as a result, the cost of the asset manager cannot be justified. Proponents of statics suggested it is more difficult for the manager to add value in the case of highly liquid investment-grade names than for high-yield names. Fitch believes while there are pros and cons to the managed nature of the CDO, a highly skilled and experienced asset manager has the potential to add value to the transaction.

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