As the search for yield continues, both U.S. and European investors are seeking new kinds of exposure to CDO equity tranches. Zero-coupon equity and rated equity pieces in investment grade corporate synthetic transactions are on the rise in Europe, Derivative Fitch noted last week. The rating agency said it has received several inquiries from investors wishing to structure rated equity transactions.
In the zero-coupon structure, the investor makes an upfront payment, and if there are either minimal or no losses over the term, the coupon is rolled-up, giving the investor an earlier agreed upon amount at maturity, according to Fitch. Rated equity is simply an offshoot of combination notes, which are generally a mix of senior notes and equity. Rated equity, however, only references the equity portion of the capital structure. In the trade, an investor purchases an equity tranche upfront; the rated coupon is nominal, and the counterparty also makes a reserve contribution, which is used to offset losses and pay the coupon over the term or at maturity.
In the U.S., more CDOs have been seen on the market that cater to equity investors - which are generally hedge funds. The deals incorporate creative interest coverage and over-collateralization triggers which divert cash to higher rated tranches, a feature which makes investing in equity more appealing.
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