Credit specialists have risen to market challenges with new products. However, the recent fashion for longer-dated synthetic CDOs could present more risks than investors realise. Natasha de Teran asks how concerned we should be about this latest trend.

Economic conditions have been testing bankers’ wits in recent times. Equity bankers, in particular, have had a tough time rehabilitating their asset class in the collective mind of an investor base that is apparently still sceptical about the products on offer.

At the other end of the spectrum, FX and commodity-related bankers have barely had a chance to take a breath in the face of the renewed interest in their sectors.

And then there are the credit specialists. Prior to the bear market, cash-hungry borrowers ramped up their credit profiles and funds poured into the asset class. But as companies moved to repair balance sheets, the environment got much tougher: as corporates tightened their belts, bankers struggled to find ways to meet investor demand. As a result, credit spreads came crashing in to record lows, yield became the most elusive commodity and complex creativity became imperative.

But structured credit specialists are nothing if not creative and they managed to come up with new sets of investment tools to meet the altered market conditions. By the time the rest of the marketplace had got to grips with the original concept of the collateralised debt obligation (CDOs – where pools of debt are ringfenced in a special purpose vehicle and sold on as securities in different tranches), they had already moved onto synthetic CDOs, their equity equivalents, repo CDOs, CDOs of asset-backed securities and CDOs of CDOs; the list, if not endless, is at least beginning to acquire a lexicon all of its own.

Latest trend

One of the most recent vogues, which has been emerging strongly over the past four to five months, is a move toward longer-dated synthetic CDOs – synthetic CDOs based on seven to 10-year underlying credit default swaps. Through these tools, structurers have managed to answer at least one investment requirement: additional yield. But there is also a danger they may have unwittingly unearthed some problems by so doing.

In the Financial Services Authority’s Financial Risk Outlook publication – an annual report prioritising the risks facing the financial sector as seen by the UK regulator – the perils of credit risk transfer (CRT) raised its head again. Although it was not highlighted as one of the priority risks itself, it fell into one of the FSA’s risk categories: risk management needs to remain rigorous within financial institutions. The FSA’s message as regards CRT was clear: “The complexity and illiquidity of credit risk transfer products carries particular risks.”

Risk awareness

The FSA questioned whether the strength of demand could suggest that investors are ‘searching for yield’ without fully considering fundamental investment risks, and then cited a Joint Forum report published in October 2004, which assessed the risks arising from CRT activity. The report highlighted three areas of concern: that many products are illiquid or bespoke in nature, and can therefore be very complex; that derivatives with longer time horizons are now available, which adds to pricing difficulties; and that one area of particularly strong growth has been investment grade-backed synthetic CDOs.

Safe structure?

Long-dated CDOs fall into all three of those categories, and there are more and more of them around. Should we be afraid? Apparently not. The bankers who put these trades together are adamant that their development is a logical extension of the structured credit market and that advances across the board make them safe and secure.

Hubert Le-Liepvre, deputy head of structured credit at SG CIB in London, says: “Doing 10-year transactions today is, in fact, easier and less risky than doing five-year transactions was even four years ago. That is because the documentation, technology and liquidity has improved over the interim. And, in general, I would say that there are no more dangers in these longer-dated products today than in the shorter-dated ones. Obviously – and as with other investment product – there is more risk in a longer transaction than there is in a shorter one, but that additional risk is also priced in.”

Market drivers

According to Mr Le-Liepvre and his fellow structurers, the move to longer-dated CDOs has been driven as much by the underlying credit default swap (CDS) market and investor demand as it has been by a search for yield.

“Traditionally the CDS market’s liquidity has been concentrated at the shorter end [of the yield curve], but now that this has moved out and there is a balanced equilibrium between buyers and sellers in the seven to 10-year range as well, we are able to structure the longer products,” says Mr Le-Liepvre.

“The increase in liquidity in the underlying CDS means we now have the ability to efficiently put these trades together where we didn’t before,” adds Matteo Sotti, director, co-head of European and Asian credit trading at Deutsche Bank in London. “There is economic rationale behind them, and investors are now sufficiently comfortable with the synthetic CDO product to extend the maturity on these investments.”

Index boost

The new credit indices have also contributed to the ease with which structurers can now put together longer-dated CDOs, according to Marcus Schüler, who works in integrated credit marketing at Deutsche Bank in London. Since the iBoxx and Trac-x credit derivative indices were merged early last year, Mr Schüler says the flow in the 10-year index segment has exploded, further facilitating efforts to put together longer-dated CDOs.

 

 Marcus Schüler, integrated credit marketing at Deutsche Bank in London 

Mr Le-Liepvre says his bank has been advising some customers that seven or 10-year CDOs could be more interesting investments for a couple of reasons. The first is the prevalent global view on the economic cycles: both SG’s strategist and others tend to think that the spread crisis is over – a view that is by no means limited to the CDO sector of the market.

The second reason is rather more technical: the significant tightening in spreads in recent months has been far more marked in the five-year paper than in the 10-year range. As a result, the spread between the two maturities has been steadily increasing: in September last year, for instance, the spread between the two was 13-14 basis points, while by mid-January this had risen to 18-19bps.

Mr Le-Liepvre adds: “A final technical reason for this is caused by the five-year CDO squared transactions that were put together last year. Dealers hedge themselves using 6%-9% iTraxx tranches, reflecting the CDOs contained within the transactions. This has pushed down the correlation in the five-year area, but not in the 10-year area where there is still some value to be extracted.”

Investors at the ready?

Of course, none of these factors would be remotely relevant were there not investors ready to take on the longer-term risk – but by all accounts there are plenty of them.

According to both Mr Le-Liepvre and Katrina Tormey, head of the CDO syndicate desk at JPMorgan in London, much of the drive towards longer-dated CDOs has come from the insurance sector.

“Insurance companies typically have longer-dated liabilities, and because they have stepped up their interest in the CDO market there has been a natural trend toward the longer-dated products,” says Ms Tormey. “Previously they were less active investors in CDOs because the regulators were naturally cautious about their entry into the market, but now that many [regulators] have relaxed their stances, and mark-to-market prices have become more readily available, [insurance companies] have become increasingly involved.”

Manager selection

Although the bankers are adamant there are no inherent dangers in these moves, they admit that the investments do require an extra degree of caution. One banker says that it is “not quite a case of Caveat Emptor squared, but somewhere close to that”.

Mr Sotti and Ms Tormey both point out that investors should be more discerning about the managers on longer transactions as well as in selecting whether to opt for a static or a managed transaction (in which an appointed manager will, within the prescribed limits, manage the exposures during the life of the CDO).

“We are obviously in a very low default environment,” says Ms Tormey, “and I think investors are therefore quite comfortable taking on default risk on a static basis for three to five years, but they should consider carefully whether they want to do that for seven or 10-year terms. The longer the transaction, the higher the chances the credit cycle changes, and the higher the default risk. We would recommend investors looked to managed transactions in the seven to 10-year area because of this, but have seen some static seven-year transactions in the market.”

Mr Le-Liepvre adds: “Investors would do well to be cautious when selecting these investments. They should be extra vigilant about the CDO managers and look to the well-established larger ones, who are fully committed to the market and who will still be there to support the transactions throughout their lives.”

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