The use of complex credit instruments is expected to continue growing as more structured products come to market and the fallout from a low yield/narrow spread climate intensifies.

Institutional investors, particularly in Europe, are warming to increasingly advanced credit investing strategies as a way of rebalancing asset/liability mismatchs in their portfolios.

Recently the focus has shifted from the use of swaps by investors to the incorporation of investment grade securities such as collateralised debt obligations (CDOs) and, in last few weeks, the use of constant proportion debt obligations (CPDOs), to meet the demand for high ratings and high yield.

In Europe, the Middle East and Africa (EMEA), the market in CDOs - defined as investment vehicles backed by a pool of bonds, loans and sometimes derivatives - was worth €101.9bn in 2006, according to Moody’s Investor Services. Of this, 30 per cent were cash flow CDOs, which reference bonds and asset-backed securities as underlying instruments, and the remaining 70 per cent were synthetic CDOs, backed by credit default swaps, forward contracts and options.

Additional research of the European CDO market by Derivative Fitch, found demand for CDOs of CDOs, known as CDO squared, and SME CDOs, which are CDOs exposed to unsecured loans and second-lien mortgages, particularly strong from Spanish and German investors. There have been 375 CDOs launched in Europe so far, Fitch found.

In recent months, against a backdrop of low yields in the credit default swap market (hitherto the derivative of choice for the fixed income investor) a new twist on the CDO product has emerged, namely the CPDO.

In the case of a CPDO – the first of its type launched by ABN Amro – it shares similarities with synthetic CDOs but, crucially, avoids the associated correlation risks that synthetic CDOs are exposed to.

A Moody’s report – 2006 Review and 2007 Outlook: EMEA CDOs – said CPDOs were aimed at risk-adverse pension funds, and “leading the catwalk ahead of last year’s has-beens… such as CDO squared… as bankers try to find new ways to reach the credit nirvana combo of high yield with high credit quality”.

Khalid Howlader, vice-president, international structured finance, Moody’s, explained: “Many [pension and low-risk] funds limit investment criteria to highly rated securities and it is this desire for high ratings and high yields that CPDOs hope to satisfy.”

However, in contrast to the comparatively mature cash/synthetic CDO market, the CPDO universe is at an early stage of development, with a handful of issuances valued at around €1bn so far, or 6 per cent of recorded CDO deals in Europe. ABN Amro set the pace with its SURF CPDO series issued in August 2006, and latterly both HSBC and BNP Paribas have issued CPDO notes.

Those researching deals on the sell-side believe CPDOs merit widespread interest from investors because of the potential for both strong ratings and high yield.

Recent CPDO deals have been awarded AAA/AA credit ratings combined with spread levels ranging between 100 and 200 basis points. Transactions seen to date receive on going premium for selling protection in the two credit indices of iTraxx and CDX.

“Offering a AAA rating on both the coupon and the principal and a very attractive spread of 200 basis points above Libor, the CPDO product seems to have appealed not only to investors in search of yield, but also to new classes of investors for whom the rating is important due to Basel II regulatory capital requirements,” said Panayiotis Teklos, credit strategist at Citibank.

Citibank research suggests that CPDO players may seek to shift from static index portfolios to bespoke and actively managed structures.

With around 10-15 providers in Europe believed to be expressing interest in issuing some type of CPDO paper in 2007, take-up is expected to be bullish.

Kathleen Currie, head of liability driven investing at HSBC Investments, believes there is no reason why credit products such as CDOs and CPDOs cannot fit within a pension fund’s fixed income investment strategy, as long as the risk-reward parameters are met.

“The illiquid nature of leveraged instruments such as CDOs is generally suited to the longer term investor and consequently we would have no problem recommending that pension funds consider some level of exposure as part of their overall LDI [liability driven investment] strategy,” said Ms Currie.

Ms Currie explains that pension fund exposure to the CDO space remains at the early stage of growth.

Paul Deane-Williams, senior investment consultant at Watson Wyatt, recognises some interest from pension fund clients in the use of more complex derivative instruments. However, like Ms Currie, he said this remains confined to inflation-linked swaps for the time being. “There is a rise in focus in the area of CDOs and it will be important, going forward, to see where this interest is applied,” he said.

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