Synthetic CDOs once symbolised the kind of financial wizardry that led to the financial crisis of 2008. A decade on, banks are again staffing up desks to trade these complex products on the back of growing demand from yield-hungry investors.
Trading volumes in synthetic collateralised debt obligations linked to credit indexes are up 40% this year, according to JP Morgan, after topping US$200bn in 2018 on the back of three years of double-digit growth. Meanwhile, analysts predict more than US$100bn in sales of bespoke synthetic CDOs in 2019 following an estimated US$80bn of issuance last year.
Behind the surge: the darkening outlook for returns in credit markets, epitomised by the trillions of dollars-worth of negative-yielding debt worldwide, which is prodding money managers towards more complex investments that promise meatier gains.
Banks are reacting to the demand. Citigroup, already a major player, has hired another two credit traders to focus on synthetic CDOs in recent months, while Deutsche Bank this year hired Manav Gupta, a senior credit trader from Goldman Sachs, in part with an eye on expanding in this market.
Barclays has plans to increase its presence in this area too, according to a person familiar with the matter. Other banks including BNP Paribas, Goldman Sachs, JP Morgan and Societe Generale have been actively trading synthetic CDOs for several years.
Market veterans draw parallels with the genesis of the synthetic CDO in the early part of the last decade. Faced with meagre returns in corporate bonds back then, traders decided to lever up their positions by slicing up portfolios of credit-default swaps into tranches with varying degrees of risk and return.
“It was to answer an issue that we are facing right now: that [credit] spreads were quite tight and investors were looking for ways to leverage returns and get more yield,” said Michael Hattab, a senior portfolio manager at Paris-based investment manager LFIS. “The best way to leverage tight spreads is [to use] tranches.”
BAD NAME, GOOD RETURNS
CDOs (synthetic and otherwise) got a bad rap following the financial crisis after bankers jammed them full of investments that proved far riskier than billed. It was the proliferation of sub-prime mortgage CDOs that transmitted and amplified losses in the US housing market throughout the financial system.
Bankers have long contended the main issue was the quality of the assets stuffed into CDOs, rather than the structure itself. And despite the stigma of resembling other complex products that were consigned to the scrap heap, synthetic CDOs have survived and evolved.
Rather than referencing mortgages as many deals did in the run up to the crisis, the new generation of synthetic CDOs now see investors taking a leveraged bet on whether corporate defaults will rise, using tranched portfolios of credit default swaps. The riskiest tranches earn the highest returns, but are on the hook first for losses resulting from any defaults in the portfolio.
Returns have been tempting in the most visible part of the market, where CDS indexes are carved into tranches. Investors in the most junior, or equity, tranche of the iTraxx Europe Main index, who continue to get paid so long as defaults remain lower than 3% for the investment-grade index, have received an average return of 8.1% a year since 2014, according to a recent JP Morgan report.
Since 2008 – and so taking in the crisis – investors made an average annual return of 5.8%. The index itself returned 1.5% annually over both periods.
Bankers say greater standardisation of structures has helped bring in more investors. In 2014, more than 50% of index tranche trading volumes came from banks, JP Morgan estimates, as trading desks hedged exposures to synthetic CDOs created before the crisis. Nowadays, 90% of volumes come from hedge funds and real-money investors, such as insurance companies.
The synthetic CDO market* is growing again after years of decline
The more opaque part of the market – so-called bespoke tranches – has also undergone a facelift. Here, an investor chooses a set of companies it wants to bet on, whose CDS are then bundled together and sliced up.
The amount of capital regulators force banks to hold against these positions strongly encourages banks to sell all tranches to investors rather than keeping them on their books, as they did in the run-up to the crisis.
Bankers say the investor mindset has also changed. Back in the day, when tranches were rated by credit rating agencies, there was a tendency to game the agencies’ methodologies to achieve the highest possible yield for the rating bracket. Now, investors are more focused on how likely it is the companies in the portfolio will default on their debt.
Prior to the crisis “the focus was on the ratings rules and not on corporate fundamentals. Now it’s the other way round and driven by investor requests where they want to get leveraged exposure to a certain name,” said Arup Ghosh, a strategist at Citigroup.
These trades are typically short-dated and rarely more than three years in maturity. That is partly because clients know banks are unlikely to offer to buy back positions if they sour, unlike in the more freely-traded index market. Hattab at LFIS says he prefers index tranches for that reason.
You “can trade in and out very easily. For bespokes it is more tricky,” he said.
Such has been the revival of bespoke synthetic CDOs that it is now affecting the broader CDS market, analysts say, prompting the front-end of the CDS curve to steepen.
“In effect you’re selling a lot of three-year CDS protection. That has driven the CDS curve very steep at the front-end of the curve,” said Ghosh.