They're still hypothetical and many think they're too cutting-edge and innovative. But synthetic CLOs made up entirely of loan credit default swaps (CDS) are definitely coming to the European marketplace, sources say.
Jeremy Carter, an analyst at Derivative Fitch in London, expects that the agency will be rating synthetic CLOs as early as mid-summer.
"The foundations that will allow for these deals are already in place and we have been having lots of enquiries from people about using loan CDS as collateral for a CDO," Carter said. "Typically, those who have done investment grade CDS deals would be arranging them in the leveraged space."
The potential to put together synthetic CLOs is, naturally, a result of the rapid growth of the loan CDS market in Europe, which itself is a direct consequence of the expansion of the European leveraged loan market. The creation of an index of loan CDSes about six months ago (market talk suggests another index is soon on its way) was a huge step in the growth process of this market, and trading in European loan CDS has increased significantly over the past year.
Markit, a leading provider of independent, multi-asset class, pricing and data services for the global financial market, estimates that about 58% of all trades in the European leveraged loan market are taking place in the loan CDS universe. This is much smaller than the 80% figure Markit quotes for the U.S. leveraged loan market, of course, but it is still significant, and sources expect that the European loan CDS market is only slated to strengthen further, spurred on both by the growth in the loan market itself and by investor demand for synthetic exposure to loans.
Indeed, loan CDSes allow investors to get exposure to loans without actually having to invest in them, said Gavin McLean, a partner at the law firm White & Case in London. They allow investors to get a broad look on the loan market, and they also offer the advantage of speed, as they are quicker to execute and purchase than the underlying assets - a plus point for those looking to put together a CLO, as "this reduces the time it takes to warehouse a portfolio," McLean said.
It's no secret that it has been extremely tough for managers of cashflow CLOs to get their hands on loan paper in Europe, given the tight competition for primary market products from an ever-increasing investor base. Being able to get exposure to loans in a synthetic way will make life easier for collateral managers in Europe, said Lapo Gaudagnuolo, director in Standard & Poor's London-based structured finance group, and this is fuel for the creation of synthetic CLOs.
Nevertheless, many in the European CLO business are wary of getting involved in synthetics, not least because the European loan CDS market is still not deep enough, they say, for these deals to be truly viable.
"There just aren't enough names out there and the main buyers for loan CDSes are still hedge funds, trading desks and the like," a source at a European CLO manager said.
"There's liquidity in the larger CDS names, but for it to be viable as collateral, you'd also need to be able to trade smaller names in the leveraged world. That's just not possible right now."
Indeed, the presence of an index does not necessarily give certainty of success and huge liquidity, Guadagnulo said. This has been evidenced in other derivatives markets, and the viability of synthetic CLOs will depend upon continued demand for loan CDS.
Another perceived obstacle which could delay the coming to market of synthetic CLOs is the prepayment nature of leveraged loans, which brings reinvestment risk, S&P analysts wrote in its European CDO Outlook 2007.' In turn, this could create some difficulties in the hedging process, the report said, "which is a key driving force behind a standardized bespoke market. However, as demand for synthetic exposure to leveraged loans is poised to increase, backed by another year of growth in the cash CLO market, which is increasingly looking to use synthetic assets, we expect structural innovations to overcome this issue."
European market sources agree that the loan CDS index definitely needs to become more liquid, and documentation of these assets needs to be standardized before a purely synthetic CLO can happen. However, things are moving quite rapidly on both fronts: Market players expect International Swaps and Derivatives Association, the leading trade association for derivatives, to release a standard contract for the treatment of loan CDS by the end of this month, and according to White & Case's McLean, this will help make the index more liquid and encourage further trading.
"As dealers finalize documentation, the indices will also become more liquid," he said. "Clearly, the foundations for CLOs of loan CDS are already apparent, and for these kinds of deals, it's more a question of when' than if.'"
For their part, the number of CLOs of leveraged loans is also slated to increase in Europe, despite tighter loan spreads and reduced arbitrage opportunities. For many investors, CLOs still offer higher returns than other asset classes, so there is still great potential for these vehicles.
Derivative Fitch will be using the same methodology it uses to rates cashflow CLOs to rate any upcoming synthetic transaction in the leveraged loan space, Fitch's Carter said. However, "if we were modeling a portfolio of loan CDS contracts as opposed to cash loans and there was a cash settlement process in place rather than a physical process, this would increase the probability of default, so you would get a worse rating on the loan CDS CDO than on the cash CDO," he said.
A thought synthetic enthusiasts may want to bear in mind.
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