Leveraged super-senior trades - which are gaining popularity in the European market - are close to making a debut in the publicly rated U.S. synthetic CDO market, with at least one rating agency looking at five of the deals. The deals achieve their leverage, generally eight-to-12 times above the super-senior tranche, by posting only a portion of the collateral's notional amount but receiving the full spread. Further separating the leveraged super-senior from a senior synthetic CDO tranche, the arranger has the option to unwind the transactions and transfer mark-to-market swap costs to investors.
The trade has gained popularity in Europe as the aftermath of the "correlation unwind" reverberates through the market, causing tight pricing in mezzanine slices of the Dow Jones iTraxx CDS index sending investors looking for other options, according to Bear Stearns analyst Gyan Sinha. "For institutions looking to put high quality assets on the books and still pay a reasonable spread, taking market-risk through leverage is pretty much the only option left in the structured credit markets," Sinha wrote in research this month.
Moody's Investors Service is currently looking at five deals from separate issuers for the U.S. market, and Fitch Ratings is currently working on "several inquiries" out of its New York office, said Fitch analyst Richard Hrvatin, who said interest was high among U.S. arrangers. The deals Moody's is looking at are on average leveraged eight-to-10-times and reference investment grade corporate names, said Moody's analyst Eun Choi.
The first such publicly rated deal rated by Moody's was Deutsche Bank's Eirles 2 Limited Series 186 & 187, issued to the European market June 20. The $50 million series 186 floating-rate credit linked notes received a triple-A rating. The deal matures May 20, 2011 and has attachment and detachment points of 10% and 80%, respectively; the spread trigger is defined with a leverage factor of eight.
The probability of default in the deals is relatively limited because of substantial credit protection in the super-senior structure, instead, the risk to investors typically lies in the CDS tranche's market value - a combination of factors including the direction of portfolio spreads and correlations, according to Moody's. Most of the market value triggers on the deals hinge on the weighted average portfolio spread. Fitch is preparing to release an updated version of its Vector model to incorporate the ability to model for spread widening, Hrvatin said, and Moody's is considering similar updates, but predicting trends in market pricing prove difficult due to a lack of historical data.
"Because of a lack of historical data available that could indicate patterns of volatility in super-senior tranche pricing, modeling the risk in this approach is "analytically challenging" Fitch wrote in research released late last month.
The leveraged super-senior deals typically have one of three unwind triggers seen in recent deals before the liability incurred from losses on the reference entity exceed the entity itself. A trigger could be based on loss thresholds, a weighted average portfolio spread, or market value spread widening in the super-senior tranche. When the market value of the tranche or funded investment falls below a trigger level, the deal unwinds.
In a leveraged super-senior transaction that is already leveraged 10 times, the risk and amount of total return are heightened because a 5% change in the underlying asset's value - in this case the super senior tranche - would equal a 50% change in the market value of the funded investment. Adding leverage to deals not only increases the potential absolute return of the investor, but also decreases the amount of cash required to get in on the deal at the onset. For example, one could leverage a $10 million deal 10 times into a super-senior tranche with a notional amount of $100 million, according to Fitch.
But in most cases, the investor has the option to either unwind the trade and take a mark-to-market loss or continue the deal by posting more collateral in a funded structure or increasing exposure in an unfunded structure, Choi added, and most investors would probably choose to continue in the deal if faced with taking a potential loss. As the exposure in the leveraged super-senior investment increases, the leverage decreases - meaning the investor earns less coupon.
"You shouldn't really go into the deal thinking that these triggers won't be hit - there is a potential for upsizing. If these triggers are hit the return is going to be more like a super-senior tranche, and not a levered super senior tranche," Choi added.
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