In October 2006, the launch of the first CPDOs had a dramatic impact on the structured credit market as traders took in the significance of a triple A product that was able to pay a spread of as much as 200 basis points. Index spreads flattened and spreads on mezzanine index tranches – a benchmark for bespoke synthetic CDO pricing – widened sharply relative to other tranches. Correlation traders speculated that CPDOs would replace mezzanine synthetic CDOs as the leveraged credit investment of choice.
Michael Peterson, Creditflux
Will credit investment with market-value defined leverage ever replace those with leveraged defined by loss attachment?
Christopher Nolan, SachsenLB
No, these products will never fully replace synthetic CDOs. The have a very different investor base. From an accounting and valuation point of view, taking the market risk of very leveraged CPPIs and CPDOs through the P&L does present problems to many investors. I can’t imagine having a €1 billion portfolio of CPDOs whereas I could run something similar to that on the CDO side at a given point in the capital structure. It’s all really a question of leverage.
Zoe Shaw, New Bond Street
Synthetic CDO tranches are a marvellously flexible product. Investors who know the names they want in the portfolio can do self-managed: they can take out names they think have deteriorated and put in better names. They can manage where they are in the capital structure. If they develop their own correlation models – as we have – they can check the bids they are getting when they are putting the portfolios together at the beginning. You also have the ability to go short and to include names with different weightings.
And the fact that you can cash the product in and make a very significant gain over par in a relatively short period of time because of the pull of the roll down is a very important advantage.
Thomas Keller, LBBW
And let’s not underestimate two other features. Synthetic CDOs have a convex risk profile as spreads change. You can combine different tranches so that the overall risk profile is neutral in terms of spread widening or spread tightening.
The other thing about synthetic CDO tranches is that they have introduced a new asset class: implied correlation, which can be traded separately from other risks. That is why I don’t think you can ever substitute CDOs with CPPI and CPDOs. In fact, I think that CDOs will become even more important in future because of the many attractive features they have.
Loïc Fery, Calyon
I agree with that, Thomas. Correlation is a new asset class and we are seeing some of the largest insurance companies and pension funds looking to add correlation as an additional asset class to their alternative investments bucket.
Ulrich Willeitner, DWS Investments
After the first CPDOs came to market there was talk that they would come to replace synthetic mezzanine CDOs. But the clear consensus here is that there are correlation products – synthetic CDOs – and there are non-correlation products – CPPI and CPDOs. Currently, most investors seem to be in the correlation product.
Vanaja Indra, Cairn Capital
I think CPPI and CPDOs will form some portion of the portfolio of the same investors who buy mezzanine synthetic CDOs. But I do not think they will replace them altogether. The rating on CPDOs certainly helps, but investors do appreciate that it has a different risk profile to a CDO.
Perry Inglis, Standard & Poor’s
A lot of the early conversations we have had with arrangers this year have focused around spread based products. I believe there will be a lot more focus in future on these products and others that people may yet develop.
But if we look back at last year, we rated around 700 synthetic CDO transactions of which only 50 or so were in any way spread based. I can see that number expanding a bit, but I don’t see any sea change taking place. I don’t think we will look back at the end of this year and see hundreds of spread based products.