LONDON - Fitch Ratings opened its Global Credit Derivatives conference last week in London with a discussion among arrangers, investors and managers discussing their take on the growth prospects for synthetic CDOs in a tight spread environment.
According to the panelists, returns on investments were higher two years ago. By contrast, current market spreads have tightened to where investors are becoming reluctant to jump in. So before they buy into these types of CDOs, they are starting to want more information about CDO managers and how the synthetic structures would perform and evolve in an economic downturn.
Some innovations that the market has seen so far this year have been the development of credit based constant proportion portfolio insurance (CPPI).
"The new spread environment is leading to innovation," said Loic Fery at Calyon, a speaker at last week's opening panel. "Synthetic structures are now using market value products like CPPI and I think we are not seeing the cannibalization of synthetic CDOs, instead the market is experiencing more diversification and CPPI is key to do that," he said.
Standard & Poor's earlier this year published a report where it predicted that CPPI would be the next big thing for synthetic CDOs in 2006. "Credit CPPIs seek to optimize returns by dynamically rebalancing the asset portfolio between a risky sub-portfolio and a risk-free one," explained Matt Wiesner, a credit analyst in the structured finance group at S&P.
Another aspect that will drive pricing this year is spread volatility - more and more investors are feeling comfortable taking spread or default risks in certain baskets.
Clouds on the horizon
The market is pretty optimistic that the current benign credit environment will remain at least for the short term. But opening panel speaker Jonathan Laredo at Solent Capital Partners said that given where the market was in its credit cycle, it is likely that it would begin to experience credit events from 2007 onwards. "If General Motors defaults early next year, I would expect to see a shock in the structured finance area," he said.
Managers may be finding it hard to distinguish themselves in the current tight-spread, low-default environment but a market shock could help investors begin differentiating between the good and bad managers. "They will see some managers failing and some succeeding, but it isn't a factor that the market has to worry about this year," said Laredo. "Its difficult to predict where the problems would come from."
Laredo believes that while it is difficult to anticipate what exactly will set the market off, it is certain that the positive trend will change going forward. "There will be credit events - that's the rule of this game," said Laredo. "Managed synthetics are a large solution to avoid credit events."
Most synthetic deals today include a managed portion in the structure. Fitch reported that a growing share of synthetic CDOs is managed. For instance, one third of Fitch rated CDOs were managed trades in 2005, up from about one-fifth in 2003.
Additionally, manager ability, the rating agency said, was put to the test after the Delphi Corp. default. The data compiled by Fitch suggests that managed transactions performed better than static transactions in terms of avoiding credit loss exposure to Delphi. "About half the managed synthetic CDOs had actually removed Delphi - the impact was, as a result, more focused on the static portfolios," explained Christiane Kuti at Fitch.
During her presentation at last week's conference on the auto sector, Kuti explained that the dynamic portfolios were able to maintain a triple-B rating while the static portfolios fell to a rating equivalent of triple-B minus. The managed deals benefited from trading out on any credit impairedness.
Where is the value?
Panelist Ibrahima Kobar at Ixis Asset Management, who both manages and invests in synthetic CDOs, said that he has been up and down the capital structure and the equity part of the CDO is where he is seeing the strongest value. "If you are able to select a good manager, you can really get paid by this type of investment," he said.
More institutional investors are taking equity direct because they are finding a better pay off in investment grade equity than high yield equity and by doing this, they don't have to pay for the gap risk.
Kobar said he was also keeping his eye on how the interest rate environment will affect the credit market and spreads. "If interest rates rise and spreads are not very tight, it could create a tough environment for structured credits," he said.
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