As the execution of traditional, fully tranched synthetic CDOs continues to be challenging, investment banks are reporting increased appetite for single-tranche CDOs (STCDO), which allow investors to choose custom risk/reward profiles.
However, Fitch Ratings recently delivered a cautionary note about STCDOs, warning these "may be a potential detriment to investors new to the synthetic CDO market." Others, particularly on the sell-side, contend STCDOs are a valuable combatant to the low spread/high volatility environment for investors, new or experienced.
The underlying structure between a synthetic CDO and a STCDO is very similar, with the exception that just one investor takes part in the STCDO, at a specific level of risk, and the originator holds on to the rest. Banks tailor a STCDO to the portfolio composition, desired spread, risk and ratings that an investor desires. Since these vehicles are structured and sold to just one investor, little information is readily available.
"Skeptics argue that dealers are still able to exert influence by attempting to guide investors in a given transaction," argued Fitch analysts in the report, issued late last month. "For investors new to the market, having the choice without the experience, lack of leverage or resources to negotiate with dealers may prove damaging."
While the primary advantage of STCDOs is for more sophisticated investors who know what they want, "there is no less of an advantage for newer investors in these structures," contends Lang Gibson, director of structured credit research at Banc of America Securities. "[STCDOs] are increasingly necessary in this volatile low-spread environment, where it is too risky to execute a fully tranched CDO."
With just one investor's input into the portfolio selection, STCDOs avoid a pitfall previous synthetic CDOs succumbed to - the negotiation process. Prior synthetic CDO selection was adversely affected by demands from investors at the lowest end of the capital structure. The result, unfortunately, was a significant number of downgrades and even a few defaults of rated tranches, Gibson said.
Fitch also raises concerns over the ability of STCDO investors effectively to hedge their positions.
Gibson counters the real concern lies not with management of risk but with liquidity. The true concern is that the credits are liquid enough to allow correlation traders the ability to adjust the deal's exposure dynamically, on a frequent and daily basis.