T hough it's been a long time coming, investors are finally seeing secondary liquidity in European CDOs.

According to Standard & Poor's, synthetic transactions continue to be a major driver in the market. Analysts estimated that 92% of European CDOs rated in 2004 have been synthetic and as a result European offices of banks are developing a range of new products and structures that accommodate this growing trend.

The growth of the market has led to better transparency. Many of the recent deals follow market standard ISDA contracts, and arrangers are employing nearly identical structures and documentation, which makes the deals more comparable.

"I think that one of the main [goals of] the market at the moment is to create more liquidity, and we have seen some real pushes to make it a reality," said one market analyst. "More dealers are setting up mechanisms to trade CDOs."

The introduction of analytic tools, such as S&P's CDO evaluator and its synthetic overcollateralization (SROC) evaluator, allow investors to better understand the value within structures. "Given the improved credit picture, significantly wider [offer spreads], increased market transparency and new analytical tools... we believe that there has never been a better time to buy well-structured CDOs with corporate exposure," reported Chris Ames in BNP Paribas' Structured Credit Observer last week.

Synthetically expressed views

But how do investors in search of arbitrage, not convinced that spreads will hold at current levels in the near term, still benefit from the bargain corporate spreads offer today? Ames at BNP suggests tuning into constant maturity swaps as a means to address the possibility of spread widening down the line. According to BNP, a constant maturity credit index (CMCI) spread allows a bond's margin to be reset periodically to the then current "n-year" (n being the constant) spread for a given credit index, which means the bond margin increases if index spreads increase.

If a five-year triple-A CDO tranche priced at six-month Libor plus CMCI - where the index spread is defined as 100% of the five-year iTraxx index spread - the spread will be the estimated value between the current five-year and 10-year iTraxx swaps. As the tranche matures, its spread will increasingly be influenced by the spread of the swap that was originally a 10-year and now is closer to becoming a five-year, explained Ames. The margin fixings will always reflect five-year spreads. In the event of corporate spread widening, an investor can still benefit by seeing the margin increase. "The continuing refinement of synthetic CDO technology removes the dependency between issued tranches and underlying cashflows, allowing structures much more flexibility in designing liability payment mechanism," said Ames. He added that an increased use of CMCI floaters, as well as other constant maturity-based derivatives, is expected going forward.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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