One of the biggest themes in the synthetic credit market in recent years has been the steady growth of the credit CPPI product under its various guises – CPPI, DPI, VPI and various other proprietary terms – and the search for ways to use the same techniques in a product with appeal to mainstream fixed income investors.
For the truth is that credit CPPI transactions have little appeal to a large part of the synthetic CDO investor base. Returns are back-ended – making them ideal for principal protected notes but unsuitable as the basis for rated, coupon-paying investments.
The appearance of CPDOs caused shockwaves in the structured credit market, since it made it possible for triple A rated notes to be created with leverage defined by a CPPI-like mechanism.
That left two quite different markets for credit vehicles using CPPI technology. On the one hand the more traditional credit CPPI business targets mainly private banks and retail investors. On the other hand, CPDOs are being bought by many of the same banks and insurance companies that are the mainstay of the synthetic CDO market.
MICHAEL PETERSON, Crediflux
As investors, what is the potential for credit products that use CPPI technology in your portfolios?
THOMAS KELLER, LBBW
These products are important for us. And in the future they are likely to become more important.
Like all other high grade investors in the current tight spread environment, we are looking for performance and spreads. And to achieve that we need to use leverage. In the past, as a major investor in financial and sovereign risk, LBBW made direct use of its balance sheet. But from a regulatory capital perspective, this is no longer efficient. So we have to look at CPPI and CPDO as two alternative ways of gaining leverage. We see synthetic tranches, CPPI and CPDO as three different formats in the same class of investments.
For us, the first consideration is the credit strategy. The format is a secondary consideration. Once we have chosen a credit strategy, we assess whether a CPPI or CPDO format would be applicable, or whether an operating structure such as a structured investment vehicle or a credit derivative product company would make more sense.
ZOE SHAW, New Bond Street Asset Management
We are prepared to invest further down the credit spectrum than Thomas. We will look at borderline investment grade tranches, for example. For us, return is very important, and leverage is something we accept, understand and manage in everything we do.
What I am interested in – because we would be a manager as well as an investor in these products – is what is the investor risk appetite for the new CPDO product. I would like to compare and contrast the risk inherent in a CPDO, particularly the high modelling risk, and see how it compares to the guaranteed bank counterparty CPPI product.
CHRISTOPHER NOLAN, SachsenLB Europe
We have been looking at investment grade credit for the past couple of years and we see CDOs as simply providing levered exposure to investment grade credit. We regard CPPI and CPDOs as second and third generation leveraged products allowing us to take exposure to credit in different ways. The choice of structure is really a function of the asset class we want to get involved in and how far down the credit curve we want to go.
Indeed, what CPPI has allowed us to do is go further down the capital structure on a principal protected basis. The majority of the structures we have done would be rated triple A as a function of the collateral that is being used and the potential to get return of principal at maturity.
CPDO is a very different animal altogether and you really need to believe the case that credit spreads are mean reverting. For some asset classes they certainly seem to make sense. We are currently looking at CPDOs on asset-backed securities for example. The two ABX CPDOs we have seen so far in the market are on the triple B minus index. Depending on your fundamental view of the US housing market, and given where triple B credit spreads are currently, it could be an attractive entry point to put on a CPDO on that asset class.
MICHAEL PETERSON
How is the investor base different for CPPI or CPDOs different from that for synthetic CDOs?
LOÏC FERY, CALYON
CPPI are principal guaranteed product which have in the past mainly appealed to investors who are not particularly familiar with credit – especially those that have invested in CPPI of equity and funds. Typical credit CPPI investors have been private banks and retail investors.
I would say that now the investor base for these products is becoming more similar to that for CDOs. One slight difference is that banks have been a bit reluctant to go into CPPI or CPDOs for capital adequacy reasons. That is changing slightly. But the driver last year was primarily the increasing involvement of insurance companies, pension funds and other non-banking institutions.
MICHAEL PETERSON
How suitable are CPPI and CPDOs for bank investors?
CHRISTOPHER NOLAN
From a regulatory point of view, CPDO is very straightforward. It has rated principal and interest. With CPPI – depending on the regulator and the type of credit exposure – you may have to go down the route of bifurcating the security. And depending on what security is used for collateral, that may result in a risk weighting as low as 20% under the standardised approach under Basle II.
So you have to compare your regulatory capital allocation against the expected return of the CPPI strategy very carefully. Given that the potential upside on CPPI can be a lot higher than it would be in a CPDO, it may make more sense to invest in a CPPI structure in a lot of instances given that your downside is also limited as a result of principal protection.
THOMAS KELLER
It is definitely much less trouble investing in a CPDO from a regulatory point of view than investing in a CPPI because it is a triple A security issed by a special purpose vehicle.
But that is a false comparison. You really have to compare a CPDO with the risky portion in a CPPI and then compare the two in terms of leverage and also market sensitivity. With a CPPI in principle you have managed long term default risk. With a CPDO you have short term default risk plus market risk.
MICHAEL PETERSON
How do you value a CPPI or CPDO?
LOÏC FERY
CPPI and CPDOs share with CDOs one obvious characteristic which is leverage. And the current market environment requires leverage to generate returns in credit. But the fundamental difference is that you do not need an implied correlation input to value a CPPI or CPDO. Of course, realised correlation will affect the performance of a CPPI or CPDO. But the fact that these are not correlation products makes it easier for some investors to understand how they work.
CHRISTOPHER NOLAN
As a bank investor it is extremely important that before we invest we have adequate models that allow us to robustly value all the positions across our balance sheet. We have spent a lot of time valuing CDO tranches at different parts of the capital structure using the various correlation techniques available.
When you invest in a CPPI you can simply choose to do a point-in-time valuation – valuing the long and short positions in the underying strategy. But if you want to really value the whole package, you have to value the gap risk as well, and that is much more difficult to do because your analysis needs to be forward looking.
With have not developed a model to value CPDOs yet. But it is something we are currently working on.
MICHAEL PETERSON
How can you assess the market risk in these products?
LOÏC FERY
The returns on a synthetic CDO are not affected by the path of credit spreads. But despite this, most investors are mark-to-market institutions. They are going to be affected by spreads when they mark it to market. So what most investors want to know when they buy a product is its sensitivity to the various risk parameters: credit spreads, correlation, interest rates, currency risk and so on. And once you have those sensitivities in place you want to make sure that the product is going to replicate the sensitivities you assumed when you bought the product.
That can make it quite hard for investors to understand CPPI or CPDOs initially. When they buy a tranche of a CDO investors have a certain amount of levearge a priori and if the weighted average spread of the portfolio moves by one basis point, then the market value of their tranche is going to move by, for example, five basis points. For CDOs, the main scenarios investors think about is the number of defaults, and the number of downgrades in a certain period of time. They do not usually think about when those events ocurr or what is happening to the underlying spreads.
However, on a CPPI or CPDO investors need to generate lots of different paths: they need to simulate different market scenarios, including not just defaults but also spreads. When we arrange deals we provide 42 simulations to investors for a given product. The key for investors is to look at the behaviour of all the different products they are being shown under the same scenarios.
ZOE SHAW
If you put a CPDO in an off-balance-sheet, commercial-paper-funded vehicle the mark to market volatility matters much less than when it is booked on balance sheet. But what does matter is the rating.
THOMAS KELLER
We have not bought a CPDO to date: we question what the ratings stability will be given the high mark-to-market volatility. We do not know if the rating agencies will keep the triple A rating when the bonds are trading at 85% purely as a result of spread widening but remain triple A from a default risk perspective. I personally doubt that a structure trading at 85% of par due to spread deterioration would maintain its triple A rating.
MICHAEL PETERSON
How stable will CPDO ratings be?
PERRY INGLIS
I would expect managed CPDOs to be more stable than unmanaged deals – just as in the single tranche CDO market. Generally, moving from a market that is static to one that is managed has created more potential for stability. So I would expect the same dynamic if the CPDO market does move to being a managed market.
Regarding the ratings of CPDOs versus other type of CDO it is too early to tell. The scenario we are focusing on most is the double hit of high defaults in a continued tight spread environment. We think it is unlikely both are going to happen together.
ULRICH WILLEITNER, DWS Investments
The current interest in CPDO has a lot to do with expectations of credit spreads. If you had done a CPDO three years ago, the mark-to-market would probably have been negative initially, given the high jumps in spreads in that period. But interestingly, your cash-in date would have moved forward as spreads tightened.
I believe the growth of synthetic CDOs has caused a structural break in credit spreads. I don’t expect to re-enter a phase where we have the same volatility of credit spreads that we have seen in the past few years.
Rather than an environment of big jumps, there would be a mean and spreads would revert around the mean. If this is true, then the CPDO product is appropriate. Rather than being a double-up or Martingale strategy – as people have described it – it would simply be a reaction to what has changed in the market.
THOMAS KELLER
I view the CPDO as a good product for investors who are insensitive to market price. Let’s not forget the concept of risk premium: due to risk aversion, the spread is always higher than expected losses. So if you are able to generate that expectation value because you are path independent, and you can stand the mark-to-market loss, it is not surprising that you are going to make money out of a CPDO.
But CPDOs, at least as they are currently constructed, are unattractive for market price sensitive investors. There is a high probability of a fairly large mark-to-market loss. The challenge of the new generation of CPDOs is to be sensitive on the market price concerns. Of course, investors will have to pay for that reduced mark-to-market volatility.