Constant proportion debt obligations (CPDOs), variations of CPPI structures, are one of the newest evolutionary steps to hit the CDO market. The spin 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. So far, all of the deals have involved investment grade corporate indices as the underlying asset. The addition of a manager to the so far static sector could be the next step in CPDO development. An innovator in the CPPI sector, ABN Amro has in place what was likely the first CPDO. Called Surf, the CPDO came to market as a three-tranche deal with a seven-year expected maturity, yielding 200 basis points. Not only are the high-yielding coupons attractive to investors, but an equally appealing feature is the ability for buyers to hold it on their balance sheets without placing it in a so-called alternative investments bucket. This is achieved because the CPDO structures offer a highly rated, stated coupon payment. The main difference between credit CPPI and CPDO structures that achieves those objectives are the lack of principal protection in the form of cash-out at the bond floor and the leverage mechanism, according to Cian Chandler, an analyst at Standard & Poor's in London. While the cost of principal protection in a CPPI structure is constantly referenced and dictates the total notional amount invested, CPDO leverage is unrelated to the bond floor, according to Chandler, who issued a report on the topic last week. There is a negative cash-out point in the structure, but it is typically set much lower than in CPPI deals, at 10% and 20% of note par. If reduction in the net asset value led to a cash-out scenario, the structure would unwind, with the investor taking a mark-to-market loss. Perhaps the starkest contrast to CPPI, CPDO strategies assume maximum leverage at the beginning of the transaction, with the exposure level decreasing as maturity approaches. While reserve fund availability in CPPI structures dictate the volume of so-called risky protection sold at any point during the transaction, CPDO structures follow a different formula. CPDOs use the difference between the net asset value of the underlying portfolio and the "cash-in" point, which is the present value of all future interest coupons plus par, according to Chandler. A key point is that the interest coupons provide CPDO structures with a fixed income that is unrelated to income generated, unlike CPPI structures. When the net asset value of the CPDO's underlying portfolio reaches the cash-in point, exposure to risky assets is reduced to zero, and the portfolio value is then invested at a risk-free rate, paying coupons and fees until maturity, upon which the note par is redeemed. This shortfall between the cash-in point and the portfolio net asset value drives the notional that can be leveraged. Because the leverage is derived from the ratio of the shortfall to the current credit spread on the risky asset, it is the inverse leverage formula to CPPI structures, which reduce notional exposure upon negative performance. Rating agencies have had a difficult time grappling with rated CPPI notes because in the "cash out" phase of CPPI transactions, interest is not paid until maturity -- a scenario that is viewed as a default.
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