The US synthetic CDO sector is expanding rapidly, but not without volatility. Spreads have both widened and rallied notably in 2005, causing some to second-guess the credit environment. But new issuance has been sustained and an emphasis on incorporating the paper into cash deals has become prevalent. By Chris DeReza.
Searching for yield, investors were more receptive to less traditional products late last year and early 2005, including corporate bond-linked synthetic CDOs where the collateral is largely investment-grade credit default swaps (CDS).
The product offers participants a short position when they feel the market is too expensive.
While popular in Europe and Asia, the US market is just now coming around to embrace the product. It is not possible to soundly estimate the size of the closed market, but anecdotal evidence across the board suggests significantly more activity than last year.
"In this environment you see people now using synthetics to find diversification," said Anthony Thompson, global head of ABS and CDOs for Deutsche Bank. "There is too much money and few assets."
Yet just when the stars seemingly aligned and conditions for synthetic CDO growth in the US looked set for the fast-track, Ford and GM were downgraded to junk, causing volatility in the indexes. Ford is referenced by 230 CDO deals and GM by 217, according to Fitch. As a result, some dealers in recent months have for the time-being backed away from offering the paper.
While autos have made headlines, they actually only make up 4.78% of the sector, according to the most recent data from Fitch. Other industries linked include energy, general retail, banking and finance, telecommunications and utilities.
"In the short-term we are not that concerned [with volatility caused by the Ford and GM downgrades], but in the long-term, if it is a trend that continues, we will have to re-think our assumptions on the market," said Michael Gerity, senior director at Fitch. "When spreads first began to widen out, we thought we would see more deals because they made more sense economically, but initially the opposite happened."
Since the volatility, the market has rallied. Several deals are heard coming, including a five-year synthetic offering from Merrill Lynch Bank USA.
The CDX NA index, referenced by the CDO synthetic market, has widened by as much as 50% at its extreme this year. But the index has since moved dramatically tighter in a rally, so the market seems to be seesawing.
And while the volatility has reverberated through some sectors in the cash market – such as secondary distressed ABS CDO paper – it has largely not affected the red-hot cash sector spread levels. Some of the pause in the acceptance of secondary distressed bonds might have been a general re-evaluation of cash positions, one banker said.
"Spreads have not backed off enough and probably won't widen enough to make it worth our while," said one source familiar with secondary trading. "We have to buy investment-grade stuff, so with the distressed paper we have to tinker with it to get the ratings up [repacking and using haircuts]. I don't see it going wide enough any time this year to make it worth our while."
"Any time you have a situation like this, people slow down on the riskier assets," said another investor. "People know that they will have to justify this to their chief investment officer."
When the bottoms dropped out on Ford and GM – even though this was largely expected – some hedge funds and others were caught stuck in a trade that sought to produce a positive carry, called the Correlation Unwind Trade.
The upshot is that the trade only made money if both legs of the transaction move in the opposite direction.
"They make a trading gain if correlation rises (that is, spreads move in a correlated fashion)," the source said.
But the trade lost money on the uncorrelated movement in mid-May, and when the hedge funds reversed the move, the strategy became even further hurt.
No arbitrage spurs activity
Despite this volatility, the synthetic market should nevertheless continue to grow at a fast clip. First, the CDX NA index has since rallied with almost as much gumption as it declined, and second, one of the prime catalysts for its growth — terrible arbitrage opportunities seen in the cash market – still exist.
This condition has caused some issuers to pull deals – most famously, INVESCO yanked its Blue Grass ABS CDO earlier this year. And spreads are tighter than ever. On multiple CLO transactions, for example, mostly all recently priced transactions have come in at 25bp over three-month Libor on the Triple A class.
Going further down in structure, certain issues have nipped and even continued the trend of breaking through historical tights. The Goldman Sachs-led Fidelity-managed Bally Rock CLO III in May, for example, priced at Libor plus 38bp on the Double A rated class, and at 73bp on the Single A. This contrasts with prior tights of 42bp and 75bp, respectively, and represent the most expensive part of CLO new issues.
In Europe, Triple A rated paper priced even tighter, with the 7.9-year tranche from Alcentra's recent JP-Morgan-led Jubilee CDO V coming at 22bp over six-month Euribor.
And demand has been strengthening for delayed draw classes as well. Normally the offerings price 1bp-2bp off the super senior Triple A portion as investors want some additional compensation for having to wait to put all of their money to work. Whatever money the investor does not put up for the initial draw is likely to be sitting on cash, waiting to be deployed at a later date.
The US$650m Atrium CLO for CSFB Alternative Capital recently priced at the established market tight. Both the US$387m Triple A and the US$100m delayed draw came in to print at Libor plus 25bp (one of the funders had strong demand for the delayed notes, so it was willing to accept the levels).
Other recent CLO delayed draw classes that priced parallel to term super-senior classes include two Morgan Stanley-led transactions – the US$759m Watchtower CLO for Citadel Limited and the US$1bn KKR Financial CLO.
Recent RMBS and CMBS CDO deals have also breached the tight, although given the collateral – specifically with mezzanine ABS CDO deals, for example – there are more swings here than in the loan sector.
Merrill Lynch, which continues to dominate this sector, recently priced the Triple A on the US$300m Northwall RMBS CDO I for Terwin Money Management at 28bp over three-month Libor. This contrasts with the levels of around 32bp December of last year on the Merrill-led Dunhill RMBS CDO.
In an effort to make the cash deals more inviting, structuring agents have been including a slice of synthetic paper down in the structure – away from an arbitrage class. While this has been a feature of many CLO deals, it is just starting to find its way into real estate structured finance CDOs. The Wachovia-led Cobalt commercial real estate CDO, which priced in the closing days of April, included a synthetic slice that accounts for six percent of the expected portfolio.
"The question is, do CMBS investors really understand synthetics?" said one investor.
For the most part, however, sources say the small synthetic slices are manageable. Ratings agency officials say these were not that difficult to get their arms around, but concede it is possible some people are biting off more than they can chew. "We might have gotten one call, which surprised me. This is something that is not so typical for real estate investors," said a ratings agency analyst familiar with the deal.
The market condition has prompted some new entrants to the market. JP Morgan, Deutsche and Citigroup are among the top US players in the space. Heavy hitters in Europe and Asia, namely BNP Paribas and Calyon, are now opening up shop in the US.
Moving toward standardisation
Over the past nine months, the Street has moved toward standardisation by meeting in working groups and sending recommendations to the International Swaps and Derivatives Association (ISDA), the maintainers of the industry-standard documentation. Participants included bankers from Deutsche Bank, JP Morgan and Citigroup.
The working groups are focusing on the asset-backed CDS arena. The unique attributes of ABS meant that the market needed a specific set of standardisation in order to get traction. Synthetic ABS trades have been completed, but they have typically been negative basis trades that used trade-specific documentation to issue synthetic CDOs of ABS.
"Lightly managed" by TCW advisors, the STACK 2005-1 synthetic high-grade deal is credited with being the first managed synthetic ABS deal and was denominated in dollars, euros and yen (US$260m, €12m and Y1.5bn). The US$122m five-year US class priced at one-month Libor plus 58bp, the US$6m five-year at 2.404 and the Y1bn 4.3-year offering came with a coupon of 1.140%. Deutsche Bank led.
Deutsche is also underwriting its third synthetic ABS CDO in as many months, with the Start 2005-A transaction for SG Asset Management. The US$500m deal is a cash CDO backed by synthetic ABS. This follows the US$112m Delta CDO 2005-1 for Wharton Asset Management in early April.