The global market in publicly traded CDOs grew from $85bn (€65bn) to $103bn between January 1 and December 10, 2004, according to Thomson Financial. A chunk of private deals are also believed to be adding significantly to the volumes Thomson is able to trace.
CDOs are being used in Europe and Asia, but unusually for an innovative product, hardly at all in the US where the Federal Reserve has just warned that some investors may not fully understand the risks attached to these vehicles and could face unexpected losses in case the credit cycle suddenly deteriorates.
Despite this, the market is thought to be growing fast in the UK, Germany, Switzerland and Scandinavia. As investors have sought refuge from the torrid equity markets of the past few years in bonds, the fixed income markets have become tougher. Credit spreads have tightened and good quality issuers of bonds have become scarce. Some direct investors have also had problems achieving diversified investment in good corporate bonds because they lack the in-house resources to research the length and breadth of the market.
CDOs present a number of attractions in this climate, according to Marcus Schueler, managing director of integrated credit marketing at Deutsche Bank. The first is diversification. As structured products comprised of packages of underlying bonds, loans and credit derivatives, CDOs provide instant diversification across a range of fixed income assets. “There is a general trend among pension funds and insurance companies to increase their allocation to the asset class of credit and they want to invest large amounts, such as $100m rather than just $10m. But in the primary bond market the amount of new issues has fallen dramatically and it’s hard to build portfolios based on the secondary bond market.”
CDOs can provide a handy route to credit investment for institutions facing these issues. “Five years ago if you wanted to allocate more to credit and you needed to reach a spread target of 100 basis points you would have bought 10 bonds of companies trading at wide spreads. You ended up with a non-diversified portfolio of risky names and the chances were high that one day you could be hit hard by one of these names defaulting. In credit, you want to minimise exposure to individual names. With a CDO you can create a large, diversified portfolio of the names you like, and use leverage to meet your yield targets by buying a tranche of this portfolio,” says Mr Schueler.
Managing risk
CDOs are also attracting investors because of the current emphasis in the industry on risk management. The products can create the sort of customised risk-return profile that is so desired by pension funds and insurers seeking to match assets to liabilities, explains Sridhar Bearelly, responsible for managed CDOs at Lehman Brothers in Europe. “A CDO takes a portfolio of investments and divides it into graduating tranches. Some are higher yield and higher risk, others are lower yield, lower risk.
“This means that a portfolio of high yield bonds, a riskier bonds class, can be assessable to lower risk investors. Other investors can obtain yield from lower yield bonds class by opting for the higher risk tranches of a portfolio of investment grade bonds.” The effect is to separate the risk-return profile from the asset class.
Different types of investors have their own rationales for investing in the various levels of CDO note, according to Mr Bearelly. At the junior end, rationales might be quite different, from pension funds simply seeking access to the asset class, to hedge funds looking to access a leveraged return in a low risk way.
Mezzanine notes are typically used by insurers, asset managers and banks, seeking to get risk-controlled exposure to such securities as single A rated bonds. At the senior level, investors tend to be dedicated funds following sophisticated CDO strategies, such as structured investment vehicles. Now even retail investors are getting involved through private banks and endowments.
James Barham, marketing director at London-based mezzanine finance specialist, Intermediate Capital Group, points out that while pension funds and insurance companies in Continental Europe have embraced CDOs, the structures have not found favour among UK pension funds.
This, he contends, is because investment consultants, the gatekeepers of the institutional market, frown on CDOs and so do not recommend the structures to their clients.
What puts consultants and many UK pension funds off CDOs, explains Mr Barham, is mainly the combination of high fees and high leverage. He says: “Investors have to take too much risk to get a return. And besides scaring investors, high leverage reduces the investment flexibility of the structure.
“For instance, restrictions related to gearing may dictate the amount to which the CDO manager must be invested in a particular underlying asset class such as leveraged loans. At a particular moment in time, the manager might deem a higher weighting in another underlying asset class such as high yield bonds to be potentially more profitable.”
Consultants in the UK are also turned off by the fact that CDOs are closed-ended vehicles which lock in investor capital for the duration of their 12-year life cycle. “Pension funds like liquidity, not closed-ended funds,” says Mr Barham.
CDOs have the potential to generate returns of 10 to 17 per cent over an eight to nine year period, according to Mr Barham. But it takes a high level of gearing to help realise such returns and pay the hefty fees these structures attract.
An investor in the subordinated equity tranche of a CDO can be liable to a management fee in the first year of 3 per cent of the value of the CDO structure. Leverage, says Mr Barham can amplify this fee to 30 per cent.
He blames high fees on the investment banks which structure and sell the lion’s share of CDOs to European pension funds and insurers.
“If the cost of CDOs came down, they would become more attractive to UK institutional investors. But if investment banks, which are transaction-based operators, were to lower their fees, it would be like turkeys voting for Christmas. It’s not going to happen.”
CDO evolution
Deutsche Bank’s Mr Schueler says investors are showing an increasing interest in new innovations, such as CDOs squared, where a CDO buys a CDO of itself. There are also CDOs cubed, where such CDOs of CDOs buy CDOs squared. But another new product, Contract Maturity CDOs (CMCDOs), is proving particularly popular, according to Mr Schueler. “Normally when credit exposure is taken you are paid a fixed credit spread and you suffer mark to market losses if credit spreads widen. But many investors are not comfortable with the tight credit spreads we have reached in recent past. With a CMCDO, very much like the CMCDS does for single names, credit spreads are floating rather than fixed, so the coupon of the tranche will be adjusted according to where credit spreads are in the future, enabling investors to participate in widening spreads.“
Further innovation in CDOs appears to be on the horizon, spurred by the strength of investor demand. Alexandre Martin Min, head of CDO investment at Axa Investment Managers, predicts that many equity derivative products will be applied to credit and CDOs based on narrower areas of the credit market are also in the pipeline. He says, “I come from the equity derivatives area, where fast improvement in technology is the norm. In the CDO world the difference between a CDO you purchased four years ago and one you bought yesterday is only slight. I’m expecting that to change soon.” He also anticipates more cross fertilisation between different CDOs and more flexible methods of financing investments.
Martin Min: expects more cross fertilisation berween CDOs
Mr Martin Min adds that CDOs will soon be used in the last place they have yet to take off in – the US. “If the big US pension funds go in, other US investors will follow and it will dramatically change the market, making it significantly more liquid.”
BENCHMARKING GLOBAL CREDIT DERIVATIVE PRICES
Investors who have shunned credit derivatives in the past might now want to take another look at the products.
The credit futures and options market is set to become more transparent and liquid following the launch last month of the first independent benchmark of global credit derivatives prices. As a result, existing credit derivatives could become more attractive to conservative investors and new products may also be created to tempt them.
Weekly “fixings” are to be made publicly available thanks to the efforts of Creditex, the electronic trading platform for derivatives, and Markit, a supplier of asset valuation information. The fixings will be figures representing the level at which credit futures and options deals are being done at the same point each week – 11am every Friday.
They will allow dealers to get a better idea of the price levels at which other people are trading. This should encourage dealers to trade more often.
“Until now there was no independent level so there was always doubt as to whether a trade was being done at a fair price and that stops people trading. Now people will have more confidence in the marketplace”, says Kevin Gould, executive vice-president of Markit.
The lack of transparency in the derivatives market stems from the fact that most instruments are traded “over the counter”, in other words directly between banks and institutions, rather than through a stock exchange, which makes public the prices of trades.
The new level of transparency will result in “dramatically expanded volumes of trades”, according to Mr Gould. He adds that more conservative investors, such as pension funds, could be using the market directly within two years. The new trading conditions seem likely to appeal to institutions such as Calpers (the California Public Employees’ Retirement System) which limits off-exchange futures and options to 33 per cent of its overall derivatives portfolio in order to control risk.
Mr Gould also predicts that the new market conditions will give rise to new products based on fixings, especially because they facilitate the settling of options in cash rather than delivery.
Credit derivatives fixings will establish the level of three European credit default swap (CDS) indices, based on prices quoted by roughly 19 banks trading on the Creditex platform.
The indices used will be the iTraxx Europe, which is based on 125 investment grade companies, the HiVol index which reflects the 30 most volatile CDSs and the Crossover index, reflecting CDSs on 35 companies whose credit rating is around the point between investment grade and sub-investment grade.
Creditex and Markit developed Tradable Credit Fixings in consultation with seven dealers – ABN Amro, BNP Paribas, Citigroup, Deutsche Bank, Goldman Sachs, JPMorgan and Morgan Stanley.
The fixings are being launched in Europe, with plans to launch them in the US at a later date.
