Synthetic CDOs, those funny-sounding transactions that ride the roller coaster credit derivatives market, have found an increasing number of friends in the U.S. While the volume of synthetic transactions has risen globally, the real story lies closer to home, as U.S. investors turned toward these transactions in large number this year.
Though it's difficult to get an exact breakdown, as different parties count differently, JPMorgan Securities estimates balance sheet CDOs - the dominant structure for synthetic CDOs in recent years - captured 37% of global funded issuance by mid-July. This compares to 27% reached during the same time in 2002.
In the U.S., the spike is more drastic. While in mid-July 2002, balance sheet deals were just 8% of the U.S. CDO market, or roughly $2.3 billion in volume, by July 2003 they comprised 25%, or $6.3 billion, according to the firm's research. Arbitrage transactions continue to dominate the U.S. market, although that dominance has shifted. Whereas arbitrage-purpose vehicles accounted for 92% of funded issuance through July 2002, by mid-July 2003 that had dropped to 75%.
"While growth in the cash-based CDO market has slowed, growth in the synthetic market continues unabated," said Jeff Prince, a Wachovia Securities CDO analyst and co-author of a new report dissecting synthetics, titled Synthetic CDOs Come of Age: An Investor's Guide. New synthetic structures and increasing interest from investors not yet familiar with synthetic CDOs created a need for a comprehensive report, said Prince.
The report is 27 pages aimed at educating investors about this rapidly evolving market, how synthetic CDOs - or SCDOs - have evolved, how they work and how they differ from their cash brethren.
Synthetics initially began as a tool for banks to hedge unwanted risk in their loan portfolios, or for regulatory capital relief. Thanks to super-senior technology and standardization, and rating agency oversight, SCDO growth expanded in leaps and bounds. For one, innovation in the market has created SCDOs that harness both balance sheet and, to a lesser extent, arbitrage. Transactions tied to corporate credits or ABS, CMBS and RMBS have also hit the market in recent years. Historically, SCDOs harnessed static structures, but the emergence of managed transactions over the last two years, sources say, is what really fueled interest in the U.S. As one CDO source noted, the U.S. market learned all too well the value of the ability to trade in and out of distressed assets.
"The synthetic CDO market is a blending of the structured products market and the credit derivatives market; therefore cash-backed investors can easily transfer their knowledge of CDOs to the synthetic CDO market," said Prince.
Also, synthetic deals price wider, which is clearly a lure, especially given the quest for yield in this record low interest rate environment. According to Wachovia, the spread on a triple-A investment in a cash-backed CLO is currently Libor plus mid-50 area, while a triple-A synthetic CDO can fetch Libor plus 70 basis points or more.
"Several synthetic CDO investments offer opportunities that have not been available in the cash CDO market, such as shorter maturities and bullet payments," said Prince.
However, the Wachovia also addresses the various risks associated with SCDOs. For one, the increased volume has not necessarily lead to a homogenous market. Structural features vary, sometimes substantially, from deal to deal.
"Understanding credit events and settlement terms is paramount," analysts said in the report. Furthermore, impact from the credit derivatives market plays an extremely strong role, with recent examples including the debate over restructuring definitions from International Swaps and Derivatives Association and its impact on the cheapest-to-deliver option.