Evolution, Evolution ... Revolution?

When buying a property, no one would dispute that location is key. In the structured credit market, most would agree that the market has come a long way in the last five years, from being a mysterious topic to becoming a frequently discussed subject in today's financial newspapers and journals.

Whilst no one can claim to have a crystal ball to predict what might be the next big thing in the structured credit arena, one could however predict some reasonable evolution from where we were, to where we are, to where we might be in the next 12 to 18 months.

What we can be sure of is that product ranges will keep on expanding, that the business next year should not comprise more than 60% to 70% of the business we do today. Without necessarily calling it a "revolution", it is clear that the structured credit market is evolving quite fast and reinvents itself very regularly.

Something reminds me of May 2005

In the last three months, the US housing market has come under the spotlight as subprime delinquencies increased significantly, leading to a widening of the ABS underlying and ABS CDO spreads. Talk of another correlation crisis in the ABS land abound, and one could perhaps draw some similarities between the current subprime market turmoil and the adjustment in the corporate correlation market back in 2005.

What was clear then was that there were a lot of opportunities for both arrangers and investors. Now we have seen that, as in May 2005, opportunities in the subprime markets are available to arrangers who are committed to the market and to investors who have seen the repricing of the capital structure as an opportunity (always welcome in the context of a depressingly low spread environment). Credit opportunity funds managed by seasoned managers who can tell good value bonds from bad are just one example.

Basel II-friendly structures are king

After taking more than 12 months to educate investors how CPPI can be applied to credit portfolios and another similar period in expanding the underlying from a static long-only indexed portfolio to a managed long/short, cash/synthetic credit portfolio, and on to managed correlation tranches, CPDOs and their variants came to market in late 2006.

Such structures are an attempt to answer investors' continued pursuit for yield in a Basel II-efficient framework. Whilst the triple-A rating given to CPDO structures is indeed an attractive proposition, Calyon is of the view that CPDO leverage is counter-intuitive: that is, the leverage increases when spreads widen. Calyon was the first bank which did not follow the CPDO route and developed a DPI-inspired R-Evolution in Q1 2007.

R-Evolution's leverage mechanism is not driven by the distance between the promised coupons and principal and the NAV of the strategy; instead it is designed to achieve an optimal leverage to reduce the loss probability and maximise the cash-in probability (Sharpe ratio optimisation).

The CPDO and its variant market have developed at an astronomical pace, similar to that of first-generation CPPI, which could be the inspiration to the CPDO market - be it managed, long/short portfolios or other asset classes as the underlying.

Something borrowed, something new

As in credit CPPI, credit structurers are not shy in copying ideas from their fixed-income or hedge fund siblings, provided that such ideas are attractive. Fund-of-funds structures have long been in existence allowing the gatekeeper to select hedge funds with different profiles and styles.

In the CLO arena, Calyon launched Confluent, the first multi-managed market value CLO with a rated equity tranche. Confluent combined a stable asset class with the fund-of-funds concept and a Basel II-efficient investment which has proven a very attractive structure. Several similar structures are in the making and could potentially be expanded to other asset classes.

The sky's the limit

With an increasing number of market participants - be they senior players like CDPCs (credit derivative product companies) or private investors through retail repackaging - credit structures will continue to evolve in a challenging yet interesting market. For existing investors, demand for new structures is part of their process of hunting for yield and diversified assets.

Innovation is key but needs to be responsive to what the market and investors require. There will continue to be new products trying to meet demand for efficient regulatory capital products or to take advantage of certain temporary dislocations in the market.

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