An increasing number of synthetic CDOs are expected to issue combination notes, as investors search for new ways to mitigate risk while maintaining yield. For example, the notes combine triple-A tranches and equity tranches, in order to give an investor the best of both ends of the capital spectrum.
Up until now, the market has primarily seen combo notes issued in the cash CDO sector. Lately, however, synthetic CDOs backed by high-grade corporate bonds have issued the notes, and an increasing number of synthetic ABS CDOs are expected to follow suit, Fitch Ratings said last week. "So far the majority of the structures seen by Fitch are a combination of synthetic CDOs referencing high-grade corporates, but we have recently begun to see structures referencing ABS," the rating agency said last week when it released guidelines for rating synthetic combo notes.
At a time when investors are searching for yield, but are wary to move too far down in the capital structure due to credit concerns, the notes offer an indirect route toward equity investment. In the European cash CLO market, where returns are perpetually tight, issuers have offered combination notes as a way to leverage returns. JPMorgan Securities earlier this year recommended the notes, along with direct equity investment, as a way to achieve alpha in the low yield environment.
The combinations can be done either synthetically or through repackaging. For example, the triple-A tranche can be combined with an unrated equity tranche in order to create triple-B rated combo notes. The structure allows issuers a way to sell equity and junior tranches to investors that would otherwise be unable to purchase them due to regulatory constraints. In a repackaging scenario, a special purpose vehicle would buy the tranches to be combined - either they would already be tailored for the issue, or they would be later combined. For synthetic combinations, the SPV enters into a portfolio CDS to gain synthetic exposure to the combined tranches, according to Fitch.
One Fitch transaction inquiry was based on a portfolio of 80 unsecured assets, mainly U.S. and European, with a 6.5 year life, BBB'/ BBB-' weighted average rating and a 12% portfolio concentration level. One prospective structure referenced 6.7% of the Class 1 triple-A notes and 100% of the unrated equity tranche, resulting in a 50/50 exposure to each. Based on the expected return of principal, the combo note was rated BBB.' The same rating was achieved for a 50/50 mix of the portfolio's class 3 and 5.
The rating agency intends to use the same criteria, such as counterparty charged asset and legal risk, for rating the combination notes as it uses to rate synthetic CDOs. Some combination note ratings will only address the likelihood an investor receives back his or her initial investment, however, depending on the individual deal documentation. The rating agency's specific model for rating synthetic combo notes is based on its VECTOR model; in the combo model, defaults are calculated quarterly. The combo tranche's rating is based on the probability of default compared with VECTOR significance levels. Because the default simulations are quarterly, the model tends to generate back-loaded default patterns for investment grade portfolios and front-loaded patterns for sub-investment grade deals.
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