CPPI (constant proportion portfolio insurance) is essentially a trading strategy designed to limit the downside of an investment. In the case of a synthetic credit principal-protected note, investors are exposed to a credit derivative portfolio which is a multiple of a reserve. The size of the synthetic portfolio varies according to its market value – if it gains in value the amount of leverage is increased and vice versa – with the aim to ensure that the reserve is large enough at any time to buy a zero coupon bond which would repay the principal on maturity. If the portfolio performs particularly badly a so-called cash-out event ocurrs - the deal is unwound and the remaining funds are invested in the zero-coupon bond.

Gap risk is an important issue for arrangers of these deals. If spreads move too quickly to allow the portfolio to be rebalanced, the bank sponsoring the deal may be required to step in to fund the difference between the value of the reserve and the cost of the zero-coupon bond.

A variant of CPPI – often known as DPI (dynamic portfolio insurance) – is in fact as common as CPPI in the synthetic credit world. In these transctions the leverage varies depending on the liquidity of the underlying exposures as well as their market value. While the first credit CPPI deals referenced fairly simple portfolios of single names or indices, more recently they have included a broad array of different credit derivative investments and strategies – often actively managed.

CPDO (constant proportion debt obligation) is a new type of synthetic credit transaction first launched in late 2006 by ABN Amro and then quickly taken up by other dealers. It uses many of the same principals as CPPI such as the fact that leverage is defined by the market value of the synthetic credit portfolio.
However, unlike CPPI the leverage in a CPDO increases if the investment portfolio falls in value and vice versa. Further, these deals include a cash-in event which means that the transaction unwinds as soon as there is sufficient income to pay all future coupons and principal.

Another key difference between credit CPPI transactions and CPDOs is that CPDOs are usually rated triple A, whereas CPPI deals are usually rated at best only for return of principal. To date, all CPDOs have been referenced to a credit index, and their high ratings rely on the fact that default risk is limited by the constant rejuvenation of names in the index.