| CPDO 101 |
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| 18/02/2007 | |
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Eric Bertrand-Vercammen, Head of Fixed Income and Credit Management at CPR Asset Management, answers this week's questions on CPDOs. 1. What is a CPDO? CPDOs are fully funded credit structures that combine high leverage with a mechanism to place a part of an excess yield in a reserve in order to secure future payments and absorb losses. In concrete terms, consider a security that yields a constant margin (Euribor 3 months + 1% to 2 %) and has a maturity of 10 years. The yield is generated on investments in the credit derivatives market, e.g. via the iTraxx and CDX indices. These indices comprise the 250 most liquid investment-grade issuers of the Eurozone (iTraxx) and the USA (CDX). Their yields represent an arithmetic mean of the issuers' spreads and their compositions are reviewed every 6 months, resulting in the pricing of a new series (the "flagship" pricing maturity being 5 years). The initial investments are made with high leverage (10 to 15) in order to pay the coupon (at current spreads, a minimum leverage of 5 is required to pay the coupons), but also to feed into a reserve towards future coupon payments and to absorb any losses resulting from a default in the indices. Leverage is adjusted automatically according to the level of the spreads and the size of the reserve. As the probability of paying the coupons increases, the leverage decreases. 2 . How would this product interest an institutional investor? These products' credit risk is highly diversified (250 issuers), thereby reducing specific risk. Furthermore, the systematic use of the iTraxx index roll means that there is only a 6-month default risk on investment-grade issuers. Furthermore, the "reserve" mechanism provides excellent visibility on the payment of coupons until maturity and, in most credit scenarios, ensures that the coupons are held without credit risk in the final years of the CPDO. The combination of low default risk and the reserve mechanism have led the rating agencies to rate these products AAA, reflecting the quality of their overall credit risk. It is also worth noting that the correlation between issuers in the market used to structure CDOs does not have any influence on prices. 3. What are the particular risks of this type of investment? There are two types of risk with all credit products: the risk of default of one or more issuers forming the portfolio and the risk of the product being marked-to-market, which is directly linked to the issuers' spreads. In the case of the CPDO the risk of default is relatively low. On the other hand, there is a high risk of mark-to-market: the leverage on the indices is such that a significant upturn in spreads leads to a substantial loss for the portfolio. For example, if the iTraxx and CDX spreads were to rise by an average of between 25 and 35 bp shortly after the launch of the product, the impact on the price would be between -5 and -6%. In comparison, when there was a hike in spreads in the spring of 2005, the iTraxx rose by up to 30 bp in two months. These price movements need to be put in perspective since the iTraxx's next rolls will be at higher levels, thus enabling the vehicle's "reserve" to be bolstered. In sum, for an investor who is not particularly sensitive to mark-to-market, it is a very worthwhile credit product. 4. Why do these AAA-rated vehicles offer such high yields? The mechanisms used by the rating agencies to rate structured credit products are based on probability models that use actual data and stress-test scenarios. By optimising structured products, it is possible to obtain very low probabilities of losses via these models and therefore to obtain an AAA rating. In the case of CPDOs, it is the reserve mechanism that enables the high rating. Several factors could explain the difference in yield compared with AAA issuers. The most likely is that the leverage attached to these products brings much more volatility into the valuation, which would account for part of the spread. Moreover, the arrival of new derivatives has led to improved risk/return ratios making these AAAs more attractive, bearing in mind that a certain form of aversion to "over-complex" models on the part of investors (the "black box" syndrome) necessitates a further premium. Lastly, structured products are always less liquid. |
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Articles of the same Serie : 101 |
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