In the wake of the Sept. 11 calamity and its impact on affected industries, issuance of tranched portfolio default swaps referencing investment-grade (IG) credits has increased markedly, writes Lang Gibson, head of structured credit products strategy at Banc of America.

Recognizing uncertainty and liquidity premiums, investors are increasingly taking advantage of wider IG spreads. Technical factors such as convertible stripping have driven the basis between credit default swaps and asset swaps to wider levels. In a spread contagion, portfolios can be created with cheap levels and without concentrations in problem industries with high default probabilities such as telecoms and airlines, says Gibson.

As a result of the exposures that many portfolio default swaps have to affected industries, investors need a degree of control over portfolio management. Over 95% of tranched portfolio default swaps have static pools.

There are two ways to make these traditionally static pools more dynamic: rights to substitution and independent management. In the former, an investor might substitute a maximum of, say, 10% annually in the pool. However there is a cost for this right that shows up in a reduced spread.

Further, liquidity risk is a vast problem for such a structure. As soon as investors are concerned about a default the credit has most likely entered junk status, making it extremely expensive to sell.

Consequently, independently managed portfolio default swaps are increasingly being structured. CDOs from Global Invest Advisors, Clinton Group, Wells Fargo are three visible synthetic managed IG deals currently in the market, according to IFR Asset-Backed Securities.

An issuer with a managed $1 billion notional synthetic IG CDO in the market concurred with Gibson. "The arbitrage has improved, investors can get the same returns on debt and equity (generally) prior to Sept. 11, but on a much higher quality portfolio with greater spreads on names like Boeing, the issuer said. "Risk has increased but not across the board," he added. "A manager can reach for yield in middle of the road names, but can also get higher spreads in good names. Take Boeing, this company is clearly going to have problems, but is likely to survive and its default swaps have been seen with an 80-90 bid/offer recently."

Synthetics referencing leveraged loans are also quite attractive, as loan spread widening has lagged other markets and still provides record high arbitrage levels, (i.e. the $3.0 billion Kondor synthetic CLO Deutsche Bank Alex. Brown U.S. is arranging for a third-party client that is slated to print by mid-November). Managed synthetic CLOs use a total return swap allowing unlimited trading by the manger, which benefits from flexibility to continually alter the portfolio as loan prepayments occur without incurring losses.

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