Synthetic credit portfolio transactions are similar to traditional cash CDOs except that the trust involved obtains credit exposure through the use of credit derivatives on an unfunded basis. The notes are issued in either funded or unfunded form to the investors. Much attention in research has been given to synthetic balance sheet CLOs at the exclusion of other synthetic credit portfolio transactions. However, with the difference between balance sheet CLOs and cash arbitrage CDOs dissipating from a pricing and performance standpoint, we find it valuable to consider other categories of synthetic credit portfolio transactions that offer advantages for both the issuer and the investor. In synthetics, the largest growth in the last year has occurred in tranched basket default swaps and managed synthetic arbitrage CDOs.
Synthetic CDOs and cash CDOs are increasingly being used interchangeably by the same portfolio manager. Consequently, full-service dealers have adapted by integrating their cash CDO business with their credit derivatives business. The result is a more efficient distribution of credit risk between protection buyers and sellers. Furthermore, investors benefit because they have access to the full range of cash and synthetic vehicles representing a variety of risk/return combinations through the same desk.