Credit investments where leverage is defined by a spread-based mechanism rather than by attachment and detachment points come in a growing number of varieties.

Arrangers have long since added to the classic buy-high-sell-low CPPI structure by allowing the leverage to vary depending on the nature of the underlying assets and strategies. Now, a new breed of CPDOs and CPDO-like structures are proliferating.

Their defining structural feature is an ability to cash in once the investment has achieved the net present value of its future coupons and principal.
Investors are only now beginning to get a feel for what all these structures mean in terms of the mark-to-market performance of their investments.

MICHAEL PETERSON Creditflux
How have credit structures based on CPPI technology evolved?

LOÏC FERY, Calyon
Initially, most credit CPPIs were unrated. Then we saw a move to a principal-only rating, and that naturally reduces the expected return. When you move to a principal and coupon rating you have to reduce the dispersion of the various possible paths.
For me, CPPI and CPDOs are similar types of products. At the end of the day a CPDO is just a CPPI where you remove the guarantee and change the parameters within which the credit portfolio is adjusted, making it wider or narrower.

ZOE SHAW, New Bond Street
A CPDO is an interesting product because you are able to earn your way out of problems. It has a special level of flexibility in its ability to readjust leverage. In a CPPI, if there is a problem you can get locked out. The threashold of protecting the principal is much higher in a CPPI than in a CPDO where the portfolio may be able to lose 89% of its value and you are still in the game.

VANAJA INDRA, Cairn Capital
Mezzanine CDOs have became very popular with investors over the last few years. But the combination of spreads tightening and improving liquidity in the underlying has given birth to a whole new array of products linked to mark to market.

CPPIs were the first of this kind and provided attractive returns to investors even in a tight credit spread environment whilst still providing the investor with downside principal protection provided by the investment banks.

But the CPPI product hasn’t been a replacement for CDOs: it has very different risk/return characteristics to CDOs; it’s much more mark to market and less rating focused. Although the CPPI product has been popular with the same investor base, it has had its limitations. Investors have found it difficult to put it into the same bucket as typical triple A mezzanine CDOs without the full rating on coupon as well as principal. Typically, CPPIs tend to be principal-only rated which is driven by the ratings of the principal protection provider rather than an analysis of the underlying strategy.

The CPDO innovation really ties these two strands of the market together. A CPDO product is similar to CPPI in that it is very much a mark-to-market-based product, but it also benefits from a full rating on both the principal and the coupon – very much like a CDO.

Although the rating of the underlying credit portfolio is important for a CPDO rating, the overriding factors for the CPDO rating are leverage, spread and market risk assumptions. And I believe it has been a real innovation to get the rating agencies to rate a product whose risk is predominantly market and spread risk. We are entering into a new paradigm here.

ZOE SHAW
It is quite interesting to see the levels of leverage used in
CPDOs. We have seen CPDOs with leverage of 15 to 20 times. That is higher than the 10 to 12 times you see in structured investment vehicles.

PERRY INGLIS, Standard & Poor’s
The average leverage in CPDOs has been around 14.
ZOE SHAW
Even leverage of 14 or 15 times seems a big leap for an investor that is not close to the credit market to take. Of course, that is just your initial leverage. With a CPDO your leverage is quite likely to come down over time, whereas with a CPPI you are going the other way: you can leverage up more as the reserve performs well.

PERRY INGLIS
I am not sure that the comparison with structured investment vehicle is a particularly good one. There is a lot to be said for the fact that a CPDO is leveraging an index and the index is cleaned every six months. You are taking credit exposure over a much shorter time horizon, which means that you are mainly taking jump-to-default risk or risk of sudden credit deterioration. That is quite unlike a structured investment vehicle, where the risk is all about ratings transition. That makes a difference to your thinking about leverage.

VANAJA INDRA
The leverages that you see in triple A rated CPDOs tend to be higher than the embedded leverage of similarly rated CDOs. However, there is no correlation risk and the default risk is also limited on the standard index based CPDOs where they are rolled regularly. The real question for investors as I see it is what is your view on spread paths? That should then determine what leverage you are happy with. It’s because the leverage was so high on the CPDOs completed last year that investors were left with an instrument that was trading above par following the spread tightening. However if spreads move the other way then it would be a very different story in terms of the mark to market, given that the starting leverage is so high.
Ideally, what you want is the ability to be able to react to your market view so that you can position yourself right based on your spread view. Clearly, if you expect spreads to tighten or remain flat then it makes sense to increase the leverage in advance of it, but then to reduce leverage if you expect some spread widening.

MICHAEL PETERSON
How do CPPI and CPDO transactions compare with synthetic CDOs in terms of their leverage and mark-to-market sensitivity?

ZOE SHAW
What I find surprising about the CPDO transactions we have looked at is how great the mark-to-market would be based on historical spreads. If you look at the approximately two year consistent historical data on iTraxx spreads the potential mark-to-market volatility is about 10%.

LOÏC FERY
That is an excellent point. And as an aside, one of the structures we are working on links expected returns to expected volatility, because that is exactly what investors want.

But the volatility of a CPDO is not very different than for a CDO. If you look at the volatility of a triple B tranche or a triple A tranche based on the iTraxx, you have a similar type of volatility relative to the amount leverage. A triple B tranche with six times leverage probably has half the volality of a CPDO that has twice as much leverage.

Depending on how it is set up, a CPDO is going to replicate the mark-to-market sensitivity of a low mezzanine tranche while a CPPI is going to behave more like equity.

VANAJA INDRA
One very important difference of a CPPI or CPDO compared to a CDO tranche is the time decay element of it. In a CDO tranche, the time decay or the pull-to-par effect is much stronger. As the triple A CDO tranche approaches its maturity not only does the duration shorten but you also get further and further away from the risk from an expected loss perspective. Hence your mark to market sensitivity will dampen over time.

In a CPPI or CPDO that is very different: you keep the risk on for longer. For example, in a CPDO you can go from a point when your transaction is performing well – i.e. high net asset value, expected cash in soon – to having an adverse market move – for example, spread widening – which then means your net asset value is reduced: you are further away from the cash-in barrier and effectively you push the cash-in date further back.

But on the flip side, there is sufficient excess carry trapped in the transaction that you should expect to cash in early anyway and hence go into a riskless instrument well before the legal maturity date.

In a sense you have two extreme scenarios with a CPDO. Either everything goes as planned and you cash in early hence you get out of the risk early. Or, you haven’t cashed in and you keep your risk on for a long time. As an investor clearly you want to be convinced that the chances of you cashing in early outweigh the chances of you cashing in late or never at all.

LOÏC FERY
The mark-to-market sensitivity of these products can be very high. One of the key problems of CPDOs is that being in and out of the money that way increases the gamma costs from the bid offer and that can affect the product’s overall performance.

When we use the term CPDO we generally mean a product that has a counterintuitive way of changing its leverage. In these products when things deteriorate you double up your position.

I have been adamant that I don’t think that kind of product works well. A Martingale strategy raises a lot of suitability issues for investors. Ideally, when things deteriorate you should try to reduce your position. We have come up with products where the leverage decreases when spreads widen, and where, under the same scenarios, you would have a shorter cash-in time than with a conventional CPDO.

PERRY INGLIS
It is not strictly true that with these structures you double up when things go wrong. The reality is more that the leverage stays at its maximum for longer under these kinds of scenarios.

VANAJA INDRA
I agree that at first sight increasing the leverage as spreads widen can feel intuitively wrong to investors but at the same time that’s exactly what makes CPDOs attractive – the ability to buy low and sell high. If you pick the timing right this can be very powerful. Although a spread widening can hurt you from a mark-to-market perspective, you can more than make up for it through the extra carry if that happens early enough in the transaction. Hence spread widening, as long as it happens early enough in the deal, is good for the long term performance of the CPDOs even though you would suffer an initial mark-to-market loss. What you certainly would not want is spreads to widen just before the cash-in date or maturity date and then not having enough time to make up for it in carry.

MICHAEL PETERSON
Perry, what evolution are you seeing in the kind of CPPI and CPDO structures that arrangers are showing you as a rating agency?

PERRY INGLIS
On the CPPI side of the market we would not necessarily see many of the developments, since this is not currently much of a rating agency product.
For CPDOs, things have evolved quite quickly from the static index to structures that include various step-up type features around the index. This may be stepping up the leverage, the coupon, the fees, or any combination of those things. But all of the structures are based around the index.

MICHAEL PETERSON
Are people talking about doing CPDOs on new asset classes?

PERRY INGLIS
Moving from corporate risk to ABS would be an obvious development for CPDOs, since products could be based around the ABX index. Though, of course, we have a very short period of time to evaluate the historical spread performance of the ABX.