S&P highlights CDOs’ evolution from risk transfer tool to investment product

Issuers are increasingly viewing synthetic collateralised debt obligations (CDOs) as a way of creating tailored investment products, rather than simply a method for transferring an entire portfolio of credit risk, claims rating agency Standard & Poor’s.

Speaking at S&P's Paris roadshow yesterday, Katrien Van Acoleyen, London-based associate director in the European structured finance group at S&P said: "The [synthetic CDO] arranger will typically select a reference portfolio, with or without the input of the investor, and offer one tranche with the rating desired by the investor."

According to one London-based credit derivatives dealer, private, bilateral deals are becoming an increasingly large part of the synthetic securitisation market. For these private deals, static credit portfolios are created off dealers’ exotic derivatives trading books. So, for example, a dealer could sell a triple-B tranche to an investor without having to issue any other part of the capital structure.

Van Acoleyen added that she expected managed synthetic CDOs to eventually predominate over static deals, as management should allow structures to be more robust during challenging credit environments.

Some investors in older synthetic CDOs have had their fingers burnt as defaults eat through tranches. Cognisant of this, dealers are pitching restructuring – that is, the swapping of troublesome names in a reference portfolio, for more attractive credits - as a solution to investment underperformance.

According to several dealers, investors are also asking them to restructure tranches issued by other firms and to create bespoke credit exposures from a portfolio of several tranches from different deals. “There are some tricky hedging issues when you are trading individual parts from different kinds of synthetic,” Alan Shaffran, London-based head of European credit derivatives at Citigroup, told Risk this month (See Risk, October: Realigning Exposures, page S6). The evaluation of correlated credit risk, for example, can be difficult at the best of times.