Bill Gross on CPDO
Because the bond market is more mathematically oriented than riskier asset markets, it stands to reason that a quest for certainty and reality in financial markets would begin there. Fed Funds at 1%, JGBs at .35%, and ?. Where is the present day counterpart where one could claim that prices could go no higher or risk spreads compress no further? We are beginning to find such evidence in the investment grade corporate bond market, the narrowing spreads of which are displayed in Chart 1.
While a rather obvious 25 or 35 basis points to 0 analogy could quickly be advanced here, a finer, more precise analysis emanates from the quantitative dissection of a new derivative credit product retailed to institutional buyers under the sticker known as a CPDO or “constant proportion debt obligation.” Without too much explanation, these multibillion-dollar instruments lever investment grade indices up to 15 times the amount invested and offer or have offered a spread of 200 basis points over LIBOR with a AAA rating. Hard to pass up I suppose, recognizing that AAA securities are by definition blue chip with rare, only infinitesimally small annual default rates. But this AAA rating is subject to numerous (more numerous than usual) subjective assumptions on the part of the rating services and in turn vulnerable to quicker downgrades than your normal AAA GE credit rating (there GE, I’ve paid you back.) My purpose in bringing up the CPDO, however is not to denigrate the rating sources or to praise GE, but to state that under PIMCO quantitative modeling, current investment grade CDX spreads , can only narrow by 3 or 4 more basis points before these CPDO instruments can no longer earn a AAA rating or offer such an attractive 200 basis point spread. More importantly, increasing multiples of leverage beyond 15x near current yields spreads cannot maintain either a AAA rating and/or the 200 basis points in yield spread that have made this derivative so attractive and in turn helped to reinforce a declining trend in all credit spreads over the past few months. The increasing use of leverage, in other words, at least as applied to this particular area, appears to have run out of its magical ability to increase returns. Investment grade corporate spreads therefore are not likely to narrow further. The perceived fat content in this supposed AAA “cream,” is as high as it’s going to get, and skim milk may eventually be the reality.
In Reality Check by Bill Gross
Previous posts on CPDO with numerous outside links:
+ CPDO For Dummies
+ CPDO
+ Credit Derivative Option for the Masses
+ Correlation traders tune in to rating methodologies
+ Bettor Math
+ Credit derivatives face test of nerve in 2007
Excerpt:
Another product threatened by wider spreads is Constant Proportion Debt Obligations (CPDOs), the structured credit vehicle launched amid much fanfare in August.
CPDOs are portfolios of credit default swaps divided into risk-free and risky tranches that together garner a AAA rating.
The risky investments comprise long positions on credit default swap indexes leveraged up to 15 times, and the combination of high ratings and returns of nearly 2 percent over similarly rated investments has in recent months attracted a storm of interest.
However, there is additional risk attached to CPDOs, analysts say.
“What you have in these structures is a whole load of leverage and ratings that are based on an extremely benign assumptions of asset volatility,” said Bob Janjuah, a credit analyst at RBS. “A decent pickup in volatility could see panic buying of protection … which could lead to an extremely painful blowout in spreads.”