Portfolio selection has driven CSO performance, says JP Morgan

In the first part of a three-part study into synthetic structured credit performance, JP Morgan finds that portfolio selection, rather than tranche thickness or subordination, has been the biggest factor affecting the performance of CSOs.

While many CSO investors have suffered losses greater than they expected, the researchers find that not all have done badly. It notes that investors in European-centric portfolios have typically outperformed cash investment grade bonds on a total return basis over the past three years. However, more common types of CSO portfolio – such as one heavily weighted towards financial names, have underperformed other investment choices.

Based on analysis of its own data and figures from Creditflux Data+, JP Morgan finds that there are two main flavours of mezz tranches: thin tranches with thickness of no more than 3%, and wider tranches of between 3% and 10%. Other common types of CSO are equity tranches, which were usually bought by hedge funds, and super senior tranches, which were often structured as leveraged super seniors.

JP Morgan finds that 74% of equity tranches suffered a direct loss, as a result of at least one default in their reference portfolio. The average loss to date in the portfolios analysed by JP Morgan is 2.2%, suggesting that equity investors bore the brunt of the losses. However, in reality, there has been a great deal of variability in the level of portfolio losses, with some suffering as much as 12.1% losses.

The investment bank calculates that 20% of junior mezzanine tranches and 2% of senior mezzanine tranches have suffered some losses. No senior tranches in JP Morgan’s sample sustained a loss. Loss performance was usually binary. That is, thick tranches mostly suffered the same degree of losses if they took any hit at all (60%) as thin tranches. Only for junior mezzanine tranches, did thickness reduce the average degree of losses.