A broader investor focus

Monte Paschi Asset Management built its synthetic CDO business from scratch, launching its first deal two years ago. Now, the firm is managing a deal aimed at Australia’s retail investors. Corso Pecori Giraldi, the firm’s head of institutional credit management, talks to Rachel Wolcott

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Monte Paschi Asset Management (MPAM) is the only Italian asset manager active in the synthetic collateralised debt obligation (CDO) market. MPAM, the fund management arm of the world’s oldest bank, Banca Monte dei Paschi di Siena, has issued six deals since the launch of its first CDO in 2003, totalling in excess of €4 billion in notional assets under management.

Corso Pecori Giraldi, Milan-based head of institutional credit management, views the CDO business as a means to capitalise on his team’s experience in managing credit, while broadening MPAM’s investor base outside the firm’s own network. “We distribute through investment banks’ networks, because the idea of our investment management company is to diversify the client base,” says Pecori Giraldi. “We want our success to be based on service to clients, not just performance.”

MPAM’s latest deal, Alpha Notes, marked another milestone for the CDO group in terms of increasing its investor base, as it reached out to an entirely different class of investors. Alpha Notes were sold to high-net-worth and retail investors in Australia in March, through Australian brokerage firms Lonsec and ABN Amro Morgans.

The seven-year A$55 million ($42.6 million) deal, arranged by Dutch bank ABN Amro, has been structured as a combo note, designed to give investors greater protection on their principal yet enabling them to take more risk on the coupon component. In a typical combo note structure, the principal is invested in a highly rated tranche of a synthetic CDO, while the coupon is referenced to a more risky tranche, usually the first loss (see box).

The Alpha Notes pay a coupon equal to the Australian 180-day bank bill rate plus 2.5%, giving an initial payout of around 8.3% a year. However, this starts to fall after just one default in an income portfolio of 115 global credits, with the coupon likely to fall to zero after the sixth default. The principal, however, is rated AA by Standard & Poor’s, and investors are protected against the first 12 defaults in a capital portfolio comprising 130 credits. Investors would be likely to lose their principal after 14 credit events.

Monte Paschi Asset Management will manage both portfolios defensively, with the aim of reducing the risk of a credit event among the reference entities. However, despite the fact that the deal is aimed at Australia’s retail investors, Pecori Giraldi says it will not affect the way the firm manages the portfolio. “Fundamentally, [managing CDOs for retail clients] doesn’t change a lot for me as an asset manager, apart from being conscious that there is a person behind the deal. That puts on a bit more pressure,” he observes. Prior deals were distributed solely to institutional clients through investment banks.

While MPAM’s CDO assets under management have grown substantially in the past two years, the management team has stayed small. Including Pecori Giraldi, it currently consists of seven credit analysts. That number will soon rise to nine with the appointment of two junior analysts in the near future. Pecori Giraldi will continue to build up staff levels slowly, but stresses that he is committed to the idea that an asset manager can maintain a relatively small team without giving up quality. “Competing on fees means having a low cost base but giving the same quality of service. We benefit from being part of a larger organisation, to which we outsource some of our activities, such as legal work or macro economic analysis.” MPAM charges between 20 and 40 basis points for investment-grade deals.

One way the firm’s CDO team creates efficiencies is by only covering credits in sectors where there is some volatility and transparency, and where it believes it can add value through its own bottom-up analysis. “We don’t cover all sectors, even though we still invest in the sectors we don’t cover. The problem is, are you able to give added value with your bottom-up analysis or not? I think other managers will have to start thinking about this strategy,” says Pecori Giraldi.

For instance, the team sees value in the autos and paper products sectors at the moment. Conversely, MPAM does not cover the financial institutions sector, although they are included in the portfolios it manages. Pecori Giraldi argues that there is not enough transparency in the financial institutions sector to make for a thorough bottom-up analysis as most of the risk is in their investment portfolios, the contents of which are not disclosed. In these cases, MPAM turns to rating agency research and analysis. “Rating agencies have non-public information, which they use to assess their ratings,” he explains.

MPAM started off in the CDO market in 1998 as an investor, and as Pecori Giraldi is an experienced emerging markets bond manager, the group started off with an investment in an emerging markets collateralised bond obligation (CBO). In 2001, MPAM decided to start managing its own CDOs, and went about learning how to manage deals.

“We decided to enter the market as asset managers and ‘went to school’. We partnered with Los Angeles-based asset manager TCW on one of its deals and that enabled us to have a little more insight on how to manage a CDO,” says Pecori Giraldi. MPAM was a sub-adviser on the GEM 6 deal, which permitted the manager to discuss the portfolio management process with TCW and learn why particular decisions were taken at a portfolio level.

When it came to launching its first deals, MPAM decided to focus on credit and use credit derivatives instead of cash bonds, believing synthetic CDOs, or collateralised swap obligations (CSOs), to be more efficient than cash structures. “We accumulated experience and had good timing to get into corporate credit, which at the time was low risk and a recovery story. Structurally, there is a big preference for CSOs because they are easier and less costly to sell. It means you can reduce costs, and everyone can benefit from that, especially on the lower-rated tranches,” says Pecori Giraldi.

MPAM will continue to issue CDOs, market conditions permitting. “To manage the interest of the client, we try to sell deals at the correct time,” says Pecori Giraldi. MPAM’s Alpha Notes deal was priced at the end of March, and benefited from a period of spread widening.

The asset manager is also looking into offering new credit products in the near future and will continue to launch CSOs opportunistically. It remains to be seen, however, whether other Italian asset managers step into the CDO arena.

Combo notes find favour with Australia’s retail investors

Combo notes have dominated Australia’s retail investor-focused synthetic collateralised debt obligation (CDO) market, with a succession of deals from ABN Amro, Lehman Brothers, Macquarie Bank and Westpac launched over the past year.

The shift to the combo note structure is partly a response to the default of Italian dairy company Parmalat at the end of 2003. Several banks launched synthetic CDOs targeted at Australian and New Zealand retail investors in late 2002 and 2003, with ABN Amro, for instance, launching four tranches of its HY-FI notes in August and September 2003, rated AA– and BBB by Standard & Poor’s.

However, the Parmalat default prompted something of a rethink. All in all, 15 out of the 24 Australian synthetic CDOs that had Parmalat as a reference entity were downgraded by S&P, while one had its ratings withdrawn following a restructuring of the transaction. Among them were the four tranches of the HY-FI notes, with the BBB tranches downgraded to BB in the first quarter of 2004.

While the downgrades have not affected investors’ principal, the Parmalat default has made Australia’s retail investors more conscious of principal risk, say dealers. In response, banks have turned to the combo note structure, giving investors greater security on their principal (typically, in the deals launched so far, by referencing the principal to an AAA or AA tranche of a CDO), while allowing them to take greater risk on their coupon payments.

In the most recent deal, ABN Amro offered two tranches of its Alpha Notes to Australian retail investors in March. Series 1 pays a coupon equal to the 180-day bank bill rate (BBSW) plus 2.5%, with the principal portion rated AA by S&P (see above). Series 2, however, was rated A, with a coupon of BBSW plus 3.4%, giving investors an initial payout of around 9.2%. While the coupon steps down after a single default in the 115-name income portfolio, the note could withstand around 10 defaults in a 130-name capital portfolio before investors start losing principal – two fewer defaults than Series 1.

Interestingly, Series 2 had to be withdrawn due to a lack of investor demand, emphasising that, post-Parmalat, Australia’s retail investors are willing to take a reduced coupon in return for greater security on their principal.

“The option of a lower-rated, higher-yielding tranche was offered to provide some choice should a higher-yielding tranche be required,” says Paul Cordeiro, director, head of repackaged and structured credit products at ABN Amro in Sydney. “Although early feedback indicated this was possible, it turned out the preference was for the higher-rated tranche, and therefore Series 2 was withdrawn at that time. It is possible that a transaction such as Series 2 would be offered again in the future if anticipated demand was sufficient.”

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