Collateralized debt obligations with an underlying of credit-default swaps on leveraged loans are being structured by dealers keen to diversify underlying portfolios. Firms looking to issue transactions include Morgan Stanley and Dresdner Kleinwort Wasserstein, while Deutsche Bank has already issued a private, balance-sheet deal. Standard & Poor's has fielded inquiries from four or five large firms for single tranche deals referencing between 50 and 80 leveraged loan CDS.
Synthetic structures will be cheaper and easier to ramp up than cash CLOs because the firm will not have to source the cash asset, a process which can take up to nine months. Jeremy Vice, head of synthetics at DrKW in London, said the asset class is attractive because it has historically low default rates, reducing the likelihood of credit events and losses. In addition, the loans offer higher recovery rates than corporate credits, said Alex Bernand, global head of structured credit trading at Bank of America in London. "Investors can get the same returns with leveraged loans than with senior unsecured underlyings, with a more limited downside risk," he noted.
"I would take a very close look at a proposal," said one asset manager, who added a synthetic structure which involved an experienced cash CLO manager would be most appealing. A handful of other buy-side officials also expressed interest but said a lack of proven liquidity in the underlying would be a barrier to their investment.
Robert Lepone, executive director and head of european loan trading at Morgan Stanley in London, said dealers face a number of obstacles, including an illiquid single name market, correlation risks and a lack of standard documentation to define settlement mechanics.
One trader said his firm will first look at adding synthetic components to cash CLOS before issuing a pure synthetic CDO. Cheyne Capital Management and Nomura International last week launched a leveraged loan CDO which allows up to 20% of the portfolio to be invested in synthetic exposures. Structurers from neither company were available for comment.