The quest for yield opportunity in investment-grade corporate paper has also led to a growing interest in CDOs that reference portfolios of equity default swaps. CDC IXIS Capital Markets is putting together an innovative European CDO that bridges the equity and credit worlds, said Stephane Handjian from the investment-grade CDO group at CDC.

"[The transaction is] based on 30 mini CDOs on second-to-default," he said. "Current levels on both markets provide the right timing for arbitrage opportunities. Each mini CDO is composed of a four-named mix of credit default swaps and equity default swaps. After synthetic investment-grade arbitrage CDOs, and CDO of CDOs, this transaction is a new step forward."

Handjian explained that the second-to-default feature at a mini CDO level minimized the equity default swap risk and reduced mark-to-market volatility. By including at least one equity default swap in each mini CDO, the structure yields attractive spreads and gives investors some diversification as well as high credit quality. "Thanks to the equity default swap inclusion, we improved strongly the asset quality to single-A from triple-B," Handjian said. "Thanks to the equity default swap, you can find good arbitrage based on excellent quality names investment-grade rated double-A versus CDOs based on pure credit default swaps, where arbitrage is poor due to the low spreads on credit default swaps even for triple-B names. So arrangers are forced to target poor credit quality portfolios - down to double-B names - in order to catch return."

The second-to-default feature protects the investor against a first-loss risk in each of the four names in mini CDO in two ways: it eliminates the idiosyncratic risk and strongly reduces mark-to-market volatility because it's not as sensitive to changes in either the equity default swaps or credit default swaps spreads.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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