Inquiries are reportedly up at the dozen or so financial houses offering access to single-tranche CDO technology. As this sophisticated product gains popularity, one new issue revving up overseas has added a twist to this emerging recipe.
Typically, investors turn to single-tranche collateralized debt obligations to restructure portfolios experiencing credit deterioration. Hitting the market approximately a year-and-a-half ago, little statistical data is readily available about this tailored CDO product. Issuance isn't expected to outpace the more traditional CDO product, nor is it designed to. According to sources, dealers have pumped out between 10 and 20 single-tranche deals globally per year.
At the start of 2003, investors' desire for advanced CDO customization was often referenced in analyst and banker pitches. Now, as the CDO market churns into its second quarter, sources report that investors are indeed trolling for customization via the credit derivatives market.
Single-tranche CDOs are essentially synthetic CDOs - thereby harnessing credit default swaps - that are created in isolation. Crafted for a single investor, they are devoid of a fully distributed liability structure, and are essentially a flexible vehicle for investment in a basket of underlying credits. They average $20 million to $60 million in size, according to analysts.
Dubbed "STCDOs" by Banc of America Securities, single-tranche CDOs are also referred to as "mezzanine-only CDOs" and "iCDOs" for instant CDO.
"Single-tranche synthetics allow investors to tailor their precise exposure to investment-grade corporate credits," said Lang Gibson, director of structured credit research at BofA, which harnesses a proprietary credit portfolio modeling technology called Lighthouse for STCDO investors. "The efficiency of the CDO market is brought to all new levels," Gibson said, as enhanced modeling tools offer dealers the ability to price tranches reflective of immediate market conditions.
One attraction of an STCDO, according to bankers, is the ease in calculating the number of defaults such a vehicle can withstand. As a synthetic transaction, it is devoid of the cash flow waterfall and O/C testing, making cash flows easy to analyze. Maturities typically occur in five-year bullets. Furthermore, because only one investor is involved, issuance is a virtual breeze when compared with the lengthy negotiations associated with traditional CDOs. The investor customizes the reference portfolio, tranche size and attachment points, and perhaps more importantly, reaction time to changing market conditions improves dramatically compared with the standard cash CDO.
While secondary market trading isn't a strong point for STCDOs yet, some investors have nonetheless extracted a second spin.
Anchor I, a 1,000 million CDO, is nearing completion in the European marketplace, overseas sources report. Managed by Dublin-based Harbourmaster, the synthetic transaction is reportedly a pool comprised of 60% MBS/ABS securities and 40% single-tranche CDOs. Sources report the STCDO collateral was handpicked in order to minimize the correlation between credits. While BofA was the lead agent, Gibson declined to comment on the overseas transaction.
The types of investors in STCDOs vary, and names are closely guarded by dealers. According to sources, the most common investors are holders of synthetic CDOs. Due to deterioration in the underlying credit portfolio, restructuring is the number one reason to create a STCDO. And as Europe favors synthetic CDO transactions over cash, the STCDO numbers are mightier abroad.
"Currently, many U.S. investors feel that they are filled up on investment-grade CDO exposure. However, due to scarcity premium, European clients still find the high IG synthetic pickup attractive relative to technically tight European comparable spread product," said Gibson. He added that European investors who want to gain exposure to the U.S. credit market but don't have a full team of credit research analysts find the STCDO attractive, given that some dealers use an independent quantitative approach to selecting the credits.
Additionally, given the relative efficiency of structuring STCDOs, investors who need managerial approval for CDOs in general are more likely to be granted that approval.
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