Guaranteed to take the credit

Constant proportion portfolio insurance (CPPI) techniques are now being extended to the credit derivatives market. But how have the CPPI products performed given the recent volatility in the credit market? Patrick Fletcher reports

The idea behind constant proportion portfolio insurance (CPPI) is not new. Conceived in the 1980s by, among others, Fischer Black, one half of the team behind the Black-Scholes option pricing model, it has been used as a way of guaranteeing capital on equity and fund portfolios for some time. However, CPPI techniques are now being extended to the credit market, with a flurry of capital-guaranteed deals referenced to credit default swap (CDS) portfolios and the Dow Jones CDX and the iTraxx credit derivatives indexes launched in the past few months.

The first credit CPPI product emerged in April 2004 – a 10-year capital-guaranteed deal from ABN Amro called Rente Booster, which paid Dutch retail investors a fixed coupon of 1.2%, with further payouts dependent on the performance of the iTraxx Europe index. But the structure has become more popular since the dislocation in the structured credit market in May.

In the aftermath of the downgrading of Ford and General Motors to junk status by Standard & Poor's on May 5 this year, correlation in the structured credit market plummeted, causing mark-to-market losses for the large number of hedge funds and dealers that were long the equity tranche of the credit indexes. At the same time, the mezzanine tranches outperformed amid continued strong buying interest from real-money investors. Spreads on the 3–6% tranche of the iTraxx Europe index have tightened from 188 basis points on May 17 to 70bp on July 21.

With spreads so tight on the mezzanine tranches, real-money investors have been looking for alternative investments. And with the equity tranche of the credit indexes now looking attractive, products that offer exposure to that tranche in conjunction with a capital guarantee are proving popular with investors. But other products have emerged offering exposure to mezzanine tranches, credit derivatives indexes or bespoke baskets of CDSs. The addition of a capital guarantee means these structures appeal to a wider spectrum of investors than those active in the collateralised debt obligation (CDO) space.

"CPPI is an old technique with equities. Now, credit spreads are too tight, correlation has crashed, and there's no more yield in CDOs. People are taking either leveraged risk – because they think that although the mezzanine correlation has broken down there is still value in the equity or super-senior tranches – or they're looking at credit CPPI because it's a new asset class and gives attractive returns," says Emmanuel Valette, head of correlation trading at Société Générale Corporate and Investment Banking (SG CIB) in London.

Certainly, the returns are enticing. SG CIB is preparing a deal referenced to the Dow Jones CDX North America and iTraxx Europe index. Called Jet Stream, the product has a projected return over its 10-year maturity of the euro swap rate plus 200bp. Royal Bank of Canada, meanwhile, has issued a seven-year dynamically leveraged product linked to the Dow Jones CDX North America Investment Grade index. With 20 times leverage on the underlying, the product, called Cedar, has a 7.4–9.8% projected annual return.

"Investors buy it because they like the capital-guaranteed nature and because it shows, in Monte Carlo simulations, a tendency to deliver good yields," says Richard Jacquet, head of structured credit marketing and sales at Ixis-CIB in Paris, whose bank recently launched a 10-year product with dynamically managed leverage, linked to the 0–3% tranche of the iTraxx Europe index with an expected return of 11.8% on average. "However, they are not a replacement for CDOs," he adds.

Marc Pantic, a structured credit engineer at SG CIB in Paris, agrees, noting that the risk/return profile on a CPPI product is vastly different to that of a CDO. "With a CPPI product, you have a capital guarantee and a return that is unknown, linked to credit performance. A CDO tranche is pretty much the contrary – you know your coupon and your spread, but you can lose up to your entire capital. It's a different type of exposure," he says.

In fact, many real-money investors are looking at CPPI products to diversify from CDO-heavy portfolios, say dealers. "We definitely think investors are looking for diversification. They are especially looking for products with no correlation of risk. The CPPI product we have designed answers these demands in the sense that all the products in the portfolio are vanilla – such as CDSs, bonds, long or short positions and indexes, so there is no correlation aspect," says Didier Campant, a senior credit derivatives structurer at BNP Paribas in London.

In July, BNP Paribas launched a CPPI deal called Dynamo, referenced to a portfolio managed by France's Crédit Agricole Asset Management (CAAM). The manager is allowed to include CDSs and cash bonds in the portfolio, and has the ability to go short, with no trading limits. It also has the ability to change the amount of leverage applied to the product.

The product has so far attracted €525 million of investment – much more than the expected €300 million. Using Monte Carlo simulation, BNP Paribas has come up with projected returns of Euribor plus 90bp for the five-year, 170bp for the seven-year and 300bp for the 10-year notes. "And that is with no assumptions on management of the leverage, so the performance could have been much greater," Campant adds.

Although the deal is capital guaranteed, Campant says there is value in using a portfolio manager in a CPPI deal. While a manager in a CDO might be more defensive, focusing on preventing principal losses, the manager of a CPPI portfolio can concentrate on adding value. "CAAM's idea was to manage CPPI in the same way as they manage their credit fund, and we have given them a lot of flexibility to do that," says Campant. "The more flexibility the manager has, the better the fund will be able to cope in difficult market conditions and the better equipped it is to capture opportunities."

Other banks have also launched deals with portfolio managers. In March, for instance, ABN Amro released a product in France with Axa Investment Managers (Axa IM). Called Patrimoine Obligation Croissance, the structure is linked to a portfolio of 120 CDSs, actively managed by Axa IM. The product raised around €70 million, almost double what the bank had expected.

Managed deals involving hedge fund expertise are also being offered. Credit Suisse First Boston, working with London-based credit specialist Cairn Capital, launched a deal called Cairn Credit CPPI 1 in April. It has a delta-neutral strategy, comprising long equity and short mezzanine tranches of iTraxx Europe. JP Morgan, meanwhile, is rumoured to be working with London-based credit hedge fund Cheyne Capital. "What we have seen is this market moving from straight index-related products, to index tranche products, to index tranche strategies. The final step will be strategies based on managed portfolios," says Peter Meijer, a vice-president in product development and franchise structuring at JP Morgan in London.

While the addition of managers can enhance the returns on the product, deals linked to the indexes provide greater price transparency and liquidity. "If a manager wants to buy some cheap, illiquid assets as part of a strategy, they will not know precisely what it is worth if they want to unwind that position later, as opposed to iTraxx, where there is good liquidity and prices are always available," says SG CIB's Valette. "There are pros and cons to each strategy, which is why we are looking at both."

"If you use a liquid tranche, you don't have to justify how you value it," adds Jacquet. "The danger is that when you do your calculations to see whether you have to deactivate your investment, you need to price the risky asset. If it's a bespoke tranche, the investor is blind and he has to trust your price. You can get into trouble when you say you were using that correlation or whatever to value the product."

However, how suited is CPPI to the credit derivatives market? CPPI involves dynamic portfolio management between risk-free assets (such as bonds) and risky assets (such as equity), with the aim of maximising exposure to the risky asset during a bull run. If, for instance, the stock market is heading upwards, more of the fund's assets are invested into equities; if the market falls, a greater proportion of the assets are invested in bonds, with the aim of ensuring that, at a minimum, the amount invested in fixed income is sufficient to provide 100% of the investor's principal at maturity.

CPPI techniques generally work best in underlyings that exhibit low volatility, such as hedge funds. If the risky asset suffers a drastic fall in prices early on, the entire investment would be shifted into risk-free assets, and the investor would be left holding a bond until maturity.

So, what happened during the dislocation in the credit markets in May? Following the downgrading of Ford and General Motors by Standard & Poor's to junk status, the iTraxx Europe index went from 42.6bp on May 5 (the day of the downgrade) to a high of 60.1bp 12 days later, before tightening back to 42.5bp by May 26. Over the same dates, the US CDX index went from 61.3bp to 77.7bp in 11 days, then tightened back in to 56.9bp (see chart).

Nonetheless, dealers stress that the products launched so far were not affected by the widening in spreads. "High volatility is definitely not good for CPPI. But most of the CPPI products we have seen in the market are structured to be able to absorb shocks larger than the ones we saw in May," says SG CIB's Pantic, adding that he doesn't know of any CPPI on pure credit that has been cashed out as a result of the May markets.

Most banks seem to have erred on the side of caution when structuring, all claiming that the risk of the product being cashed out entirely is extremely slight. Pantic says the market would have to widen by around 60–70bp for Jet Stream to unwind. Dynamo would need an 85bp move in a day, according to Campant; while Jacquet says Spring needs a move of 2.5 times the spread of the index. With iTraxx Europe at 40bp, that means a 100bp move in a day.

Pantic, however, highlights the dangers of being too aggressive in the use of leverage. Although products may not be cashed out, the manager can put the returns of the product at risk through being too highly leveraged. "If you have good performance but don't cap the leverage, you keep putting the whole performance at risk. The risk here is that you have too aggressive a leverage policy, and at the first crisis, you don't go to the zero coupon, but you lose most of the performance of the product," he says.

There are, however, other risks. With an unexpected drop in interest rates, the level of the cushion – the difference between the net asset value of a product and the cash level required to guarantee capital – will shrink. "You have to de-leverage, not necessarily quickly, but you do. You may well have had a good performance on your credit strategy, but because rates have fallen, you have less room to take exposure," says Pantic.

It is possible to hedge this risk using interest rate derivatives. However, this strategy may well be prohibitively expensive. Pantic says the bank considered using interest rate derivatives on Jet Stream, but eventually dismissed the idea. "Given the premium and the potential performance, it was too big a cost for the perceived risk. We discussed it with clients and we think there is more potential for upside on interest rates than downside," he says.

Although emergence of credit CPPI is seen as important, it is to some extent a result of market conditions. "If spreads were still at 100bp and correlation was still high, it would not have evolved as fast," says SG CIB's Valette. But dealers also agree that having a critical mass of products from a range of institutions definitely helps. "What is good is to see a lot of the other banks also selling these products. In this sort of market, typically you need other players to grow it with you. If you're the only one with a nice product, sometimes it hurts you," says Emmanuel Lefort, who is in charge of credit CPPI at Ixis-CIB in Paris.

However, if the market grows, dealers are predicting the emergence of new structures that will expand the product's appeal. JP Morgan's Meijer thinks demand will come for higher-yielding products with only partial capital protection. "I think you have different investors with different appetites. What you might start seeing is only partial principal protection, say 80%."

But if market conditions change, then demand for the products could fall. Jacquet, for one, doesn't want to get too carried away. "It's a new toy, it's interesting, but it's too early to say whether there will be an active market in the long run."