CPPI transactions have moved from being largely static to being mostly managed.

Will CPDOs move the same way? At the time of publication, no CPDOs have used a manager. But managers, arrangers and rating agency analysts are putting a lot of time into working out how managers could add value in these structures.

Michael Peterson, Creditflux
Are managed deals the way of the future for CPPI and
CPDOs?

Loïc Fery, Calyon
Managed deals are the next natural step for the market: usually investors are willing to pay something for a manager that has a positive impact on the performance of their investment.

Of course, management of CPPI or CPDO is much more complex than management of a CDO. And as with anything complex, you have to pick someone who really knows what they are doing. It is not obvious that all managed CPPIs and CPDOs will have better performance than static or, rather, automatically rebalancing deals.

Michael Peterson
What value can a manager add to these products?

Ulrich Willeitner, DWS Investments
CPPI is quite an old concept. It started with static pools, and then it became obvious that a manager can add value because purely rule-driven investments cannot adapt if the market changes. 

Today CPDO is an index product. But we believe the next step for this product will be to have a manager. The positive aspect of CPDOs – the semi-annually cleansing of riskier names from the portfolio – could be performed by the manager, and that would reduce the roll costs. It might also make it possible to create structures with a slightly lower level of leverage – which, as Zoe points out, is currently quite high.

At DWS the biggest chunk of our business is managed synthetic CDOs. With those deals, the role of the manager is to combine credit selection skills with structural skills – that is, analysing correlation and combining it with credit selection – and to avoid negative developments, that is, defaults and downgrades of single names.
In a CPPI the role is different. It is more about alpha generation, and it offers more flexibility than a CDO. You don’t have to think about correlation. You can put on shorts, curve trades, and so on. You can be a lot more active in putting trading ideas into practice.

Michael Peterson
What strategies make most sense for CPPI products?

Ulrich Willeitner
Obviously it depends on the market. Currently, spreads are very tight so we don’t like to employ the maximum leverage. Should there be spread widening we want to be ready to benefit from that by being in short index positions.

Short strategies are now the name of the game for generating alpha. One way is to short a very expensive name and pray for it to default – which can be a very expensive strategy. A better and less expensive way is to short the names that are tight given their underlying credit quality.

Vanaja Indra, Cairn Capital
The interesting thing about market-based products generally is that they are a lot more like managing a hedge fund than managing a synthetic CDO. That gives more opportunity for the manager to outperform and to shine based on their own management style.

This means that as an investor you have to believe in the manager 100%. With a CDO tranche you are getting the manager on board to select the right credits based on long term credit fundamentals. With a CPPI, credit fundamentals certainly still play a part, but there are so many other factors, such as the technicals surrounding the index rolls, your view on spreads and what leverage ought to be, understanding the demand-supply dynamics of the market so that you can position yourself correctly and adding the maximum amount of alpha for investors.

For a manager of a leveraged credit instrument, the most important thing is to have sufficient flexibility within the structure so that you have the tools to react to any market condition. In order to perform better than the automated product you need to make sure you have enough time to roll, flexibility around the leverage, ability to go long and short names and so on. In a CPPI transaction, a manager needs to make sure that the CPPI rules are not so restrictive that it stops you from reacting as you would wish.

Thomas Keller, LBBW
How can a manager generate alpha in a CPDO product? This is a long-only product, so you can’t be independent from the overall market trend.

Vanaja Indra
There’s plenty of opportunities to add alpha even within a primarily long product. There are always single name events, LBO rumours and so forth to generate alpha from. A manager can also trade the leverage actively to generate further alpha. 

The fact that you can buy low and sell high in a CPDO is a nice feature. But in an automated structure – especially if you start with the maximum leverage – you are not able to take full advantage of that feature. In a managed CPDO you could start out with a lower leverage but have ability to go higher or lower over time. As the index widens you could go more long. As it tightens you could unwind some of your longs. It is true that this is still a net long product but as a manager you can trade around the structural positive gamma and lock in alpha as a result.

In general terms, getting good execution is a key role a manager would play in these transactions. If you saved half a basis point at every roll and you assume the deal is 10 times leveraged, you could save roughly 45 basis points per annum. That is a very big saving.

Ulrich Willeitner
A manager could allow investors to avoid one big pitfall of the CPDO product.
Imagine a scenario in a CPDO where you have widening spreads and increasing leverage. Now imagine that five of the 125 names in the index are downgraded to subinvestment grade and your portfolio average spread widens from 25bp to 40bp as a result. Now, in an automated product you should increase your leverage. But, on the roll date the five names which have driven spreads higher drop out of the index. You have to take a loss at the roll, and the new index has the same spread as before.

If this happens several times then the CPDO mechanism – which we agree is a good idea – would not work. That is one reason why we think we need a new structure that avoids this situation with the roll. A manager’s biggest contribution to a CPDO could be to control the portfolio and avoid these negative events.

Thomas Keller
But that would undermine the concept that Perry describes of the CPDO taking only short-term default risk. If spreads on specific names deterioriate and you don’t take them out, then you are back to long-term default risk.

Ulrich Willeitner
Many of the details of the structure we are thinking of are still under discussion. But the product would need to combine the advantages of having a manager with the benefits of removing the names which threaten to be downgraded semi-annually.

Loïc Fery
I can imagine a deal where the manager has a commitment to cleanse the portfolio of the wider spread names periodically. It would still be a bespoke portfolio, but the manager’s role would be to remove the high-spread names sistematically.