“The impact of synthetic CDOs plays a bigger role than is often appreciated,” says Duncan Sankey, head of credit research at Nomura, “particularly in the case of less liquid credits. Synthetic CDO issuance is growing apace, but people tend to focus on traditional flows and ignore the fact that synthetic CDO flows fuel a good deal of spread tightening by creating net shorts in the market.”
“Synthetic CDOs are the big invisible hand,” he adds, “though it is hard to gauge their influence with precision because data is largely anecdotal.”
Matt King, European credit strategist at JPMorgan, agrees that in the last six months CDOs, and in particular synthetic CDOs, have had an important impact on spreads in the cash corporate bond market.
“There isn't a great deal of triple-B or double-B rated paper in euros, and what you can find isn’t all that diversified. This makes the synthetic route key,” he says. “While there is quite a lot of better-rated paper in the market, this does not have sufficient spread to be used in CDO issuance.”
Adds King: “Synthetic CDOs do have a big impact on the cash market, but it can be hard to tell exactly how much. Other factors, such as the improvement in the macroeconomic environment, also impact spreads. That said, any time there is a lot of synthetic CDO issuance (as has been the case last October and during the first couple of months this year), it creates a colossal short position for the issuing banks. Spreads usually tighten strongly thereafter as banks scramble to cover that short. We suspect that this process has been one of the factors that has made March a near-record month for spread tightening.”
CDO issuance is expected to remain at healthy levels in Europe. “Despite recent knocks there is definitely a market in Europe for exposure to credit on a portfolio basis,” says William Ross, international structured credit research, Merrill Lynch. “To compensate for recent concerns we will see a greater evolution in the underlying assets and greater product innovation in the CDO market, away from the high-yield arbitrage to collateralised fund obligations and private equity CDOs.”
There has been more than €30 billion of euro-denominated synthetic CDO issuance since the start of last year. “This year’s number may come out smaller than that,” says JPMorgan’s King, “if spreads tighten in sufficiently to make it unattractive to do the issuance in the first place.”