After much talk, it appears that Cairn Capital will produce the first managed CPDO, to be sold by arranger JPMorgan Chase & Co. The deal is among the latest in a string of variations on ABN Amro's flagship CPDO product, Surf, which debuted last Fall. While a number of investors are still scratching their heads as to how, exactly, the structure works, arrangers are cooking up plans for all sorts of CPDOs, including managed deals, those that reference the ABX indices and those that reference bespoke portfolios.
BNP Paribas recently came to market with its Recipes CPDO, referencing the iTraxx and DJ CDX. The Moody's Investors Service triple-A rated notes yield 100 basis points over three-month Euribor. ABN is also in the market with its Chess deal, carrying a triple-A from Standard & Poor's. While the first CPDO deals yielded some 200 basis points over Libor, compressed index spreads have currently diminished returns, making it more difficult to earn a triple-A rating at the juicy returns promised months ago.
The CPDO structure has drawn its fair share of criticism. At first glance, perhaps the most troubling feature of the CPDO is that it appears to chase losses, market participants say. That is, the wider spreads go, the more the structure seems to leverage investor principal. Some say rating agencies are bound to revise their methodology for the structures, while others worry that the boom in CPDOs, most of which reference corporate indices, could leave room for manipulation such as front-running.
The CPPI comparison
The CDO spin on CPPI helps to revise some of the rating and valuation challenges posed by the constantly changing nature of CPPI. Unlike CPPI, the principal is not protected. The deals essentially achieve a triple-A rating, on both principal and coupon, by providing a fixed coupon that increases in leverage as the underlying reference obligation's spread widens. When enough leverage is achieved to pay off the coupons and principal payments, the deal unwinds into a low-risk bond. Adding to rating agency comfort, the reference portfolio is rebalanced every six months when the referenced credit indices roll into a new series - helping to defray the risk of default or downgrade on names in the series.
There had been a fear that CPDOs would effectively drive the indices they reference - right now mostly the iTraxx and DJ CDS - into the ground. But proponents said such a reaction is unlikely, as the CPDO structure buys back protection after the market rallies and sells when spreads widen, according to a Citigroup Global Markets report.
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