Structured credit squeezes bearish trades

Structured credit squeezes bearish trades

By Paul J Davies

Published: November 6 2006 22:31 | Last updated: November 6 2006 22:31

The rally in European and US credit derivatives markets may have its base in a better outlook for corporate debt but it is the sudden hype generated by one new kind of structured product that has really caught traders off guard and put the squeeze on bearish positions.

This product, which allows investors to make a highly leveraged bet on the credit derivative indices, did not exist until this year, and only came to light in August following the first large public deal from ABN Amro.

ADVERTISEMENT

Since then, ratings agencies say that almost every investment bank has been working on or selling these deals, known as constant proportion debt obligations (CPDOs).

Up to $1bn worth of deals have been issued since early September and several times that are due to hit the market this year, according to bankers, but the key to their impact is in the leverage they employ.

According to Paul Mazataud, a managing director at Moody’s, such deals typically begin with leverage levels of 10-15 times, which means $1bn worth of deals would add up to $15bn worth of unexpected protection selling in the same time frame, putting pressure on spread levels.

The effects of this can be seen in the main iTraxx Europe index of investment grade credit default swaps, which provides protection against default for a basket of companies.

The spread, or protection premium, for a five-year contract on this index has collapsed in the past month from just above 30 basis points to about 22bp, according to figures from Markit Group. However, Andrew Whittle, a managing director in structured products at Barclays Capital, says the arrival of CPDOs in the market is as important as the amounts they trade.

“The significance of CPDOs is more than simply the amount of protection sold, which is probably not enough in itself to cause the tightening we’ve seen in the past couple of months,” he said.

The arrival of these products had materially changed the factors at play in the indices, which meant that those who were taking a bearish view of credit through short positions had to adjust their trades, he said.

Lisa Watkinson, head of structured credit business development at Lehman Brothers, also thinks the actual trading impact of these deals has not been huge.

“The market on average is seeing $30bn-$50bn in index trading a day across the iTraxx and CDX, so its probably the hype around these deals or the fear of a wave of protection selling that is moving the market,” she said.

The CPDOs sold so far work by taking a a series of very large bets on CDS indices in order to quickly generate enough income to pay a coupon of about Libor plus 200bp annually over 10 years.

Investors are exposed to the risks not just of companies represented in the indices defaulting, but also of sudden increases in the premium that the indices pay.

And because the structure will increase leverage if there are losses in a deal, in order to generate higher incomes and try to recover those losses, they can behave like a gambler chasing bad bets.