You knew it was coming. Several CPDOs that reference the ABX.HE indices are in the oven, according to industry sources. Just a short time after this type of deal's debut, the CPDO structure - a new spin on CPPI - is garnering a lot of attention.
CPDOs essentially allow investors to sell leveraged protection on the equity tranche of a synthetic CDO using a total return swap. The notional value of the swap fluctuates in order to maintain a constant degree of leverage. This CDO spin on CPPI helps to revise some of the rating and valuation challenges posed by the constantly changing nature of CPPI - a move that is expected to garner a wider investor base and thus more liquidity for the sector. In fact, at least three deals have come to market in just the last two weeks. So far, all of the deals have referenced the broad corporate synthetic indices.
Referencing the ABX Index presents a whole new set of challenges in terms of developing ratings methodology. There is little historical data to rely on, and volatility is high - particularly at the triple-B index, Yuri Yoshizawa, a managing director in the CDO group at Moody's Investors Service, said.
Tight spreads spur creativity
But if the last year is any indication, the deals will be done. Innovation has become a common theme in the CDO sector, which can thank high investor demand and, subsequently, tight spreads for the creative inspiration. Moody's alone rated $88.1 billion worth of CDOs in the third quarter, up 28% from the second quarter and more than double the $41.6 billion rated in the third quarter of 2005. The rating agency is expecting a 55% increase in overall CDO volume for this year compared to 2005. "Really it has been crazy in terms of volume," Yoshizawa said.
Indeed, synthetic CDOs could be called the most popular CDO right now. Moody's rated 64 of the deals in the third quarter, and, if hybrid CDOs are factored in, they would comprise 48% of all the CDOs the rating agency rated in the third quarter. While mezzanine securities used to be the primary fodder for hybrid deals, more have begun to move into high-grade territory.
And more creativity
Moody's is also anticipating more CDOs of CDOs this quarter than in the third. So far, this is ringing true. A number of CDO squared have come to market recently. Among them, Merrill Lynch earlier this month brought the $502 million Centre Square I, a CDO squared managed by Petra Capital Management. Interestingly, several CDO squared deals expected this quarter will be hybrids, which reference both cash and synthetic CDOs. Along those lines, CDOs in general are expected to incorporate larger buckets of CDO collateral. A number of recent structured finance CDOs have incorporated larger buckets for fellow structured finance CDOs. For example, the hybrid structured finance CDO Tallships Funding 2006-1, brought by Citigroup Global Markets and managed by Bear Stearns Asset Management, came to market recently with a maximum 30% bucket for CDO securities.
Another trend anticipated to carry over into yearend is the absence of overcollateralization and interest coverage tests, a structural modification aimed at making CDO equity investment more appealing. The idea is to skip the inclusion of triggers designed to preserve cash flow to the higher-rated tranches amid a downturn in portfolio credit quality. In exchange for the trigger-less deals, managers are generally required to provide heftier tranche subordination.
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