Dealers are becoming increasingly interested in extending repo financing - a form of leveraged investment common in a number of asset classes - to would-be CDO investors, according to JPMorgan Securities.
As global outstanding CDO volume is set to breach the $1 trillion mark, the sector's growing liquidity and investor base offer a more sound investment for dealers than it used to. However, the terms of the arrangements - largely, how much money is invested upfront - depend on the dealer's balance sheet capacity and familiarity with the security, the security's liquidity and credit quality, as well as borrower credit quality and leverage.
Repo financing offers the opportunity for leveraged investment - one can express a view at the top of a deal's capital structure while still generating yield - and for use as a market indicator, according to JPMorgan. Investors with a limited amount of money to start with, such as hedge funds and proprietary trading desks, can use the agreements as a stepping stone toward CDO investment.
When comparing the internal rate of return of term funding with repo funding for a clean, par-priced, triple-A rated CLO investment, JPMorgan found an IRR of 6.67% with the repo method, versus 0.20% with term funding. In the term funding case, JPMorgan assumed the investor nets the security coupon minus capital funding cost, yielding the annual 20 basis points. In the repo scenario, the financing cost equaled the investor's private funding cost, again leading to a 20 basis point annual gain. The leverage of 33 times yielded the 6 2/3% annual return.
Essentially, the agreements allow would-be investors a way to gain a leveraged investment by selling the securities to a counterparty for a specified period before repurchasing them at an earlier agreed upon price. The counterparty contributes to the advance rate when the security is initially purchased. Upon repurchase, the buyer repays that advanced amount plus a financing cost, but keeps all coupon or principal payments earned on the security during the repo term. Terms of the deals most often are short-term - from one to 30 days - but may stretch for as long as 12 months in the context of CDO investment. Upon expiration, the parties generally continue the financing at the same or similar terms.
During the financing term, the rise or fall of the security's market value could cause payments between parties - the reason why substantial secondary market liquidity is important in these deals. For example, if the CDO investment's market value fell by $10, the buyer would have to pay the financing counterparty $10, effectively lowering the buyer's leverage. Conversely, a gain in the security's value would increase the buyer's leverage.
While triple-A tranche returns will be more sensitive to credit performance, subordinate tranches, although armed with more credit enhancement, will be more likely to suffer material losses. Investing in the highly rated tranches can enhance yield without idiosyncratic credit risk, although investors with a rosy short-term outlook could apply leverage through repo to wide subordinate CDO spreads on a short-term basis, JPMorgan recommends.
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