Merrill Readies Novel Loss-Capped CDO

Merrill Lynch has structured a single tranche collateralized debt obligation that uses caps to limit investor exposure to portfolio losses triggered by systemic risk.

  • 16 Sep 2005
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Merrill Lynch has structured a single tranche collateralized debt obligation that uses caps to limit investor exposure to portfolio losses triggered by systemic risk. The transaction is believed by officials at the firm to be a first-of-a-kind deal in that it caps correlated sector-specific risk. The structure aims to curb portfolio losses caused by volatility in a single market sector, such as those sparked by turbulence in the U.S. autos market earlier this year. The CDO will be managed by SG AM Alternative Investments, which will supervise the underlying portfolio of AAA- and AA-rated corporates, as well as identify systemic risk exposures throughout the life of the trade.

An official familiar with the bespoke deal said Merrill has set caps on sectors where systemic risks, such as leveraged buyouts, litigations and commodity price movements, are acute. "Specific issues can trigger these sectors to behave badly and then cause losses in the portfolio," he said, adding, "This trade will put a ceiling on those losses." For example, if the portfolio experiences 10% losses on a defined sector, the percentage of loss passed onto the investor is capped at 2%.

An official at Merrill said investor returns will be competitive with standard single tranche CDOs, but details of how the firm will price the deal and offset portfolio losses above the caps could not be determined by press time. Malik Chaabouni, co-head of synthetic credit structuring at Merrill Lynch in London, declined comment and Jolyon Barthope, spokesman for SG AM Alternative Investments in Paris, did not comment by press time. A credit official at a U.S firm said this trade is a clever way to address market concerns about systemic risk, which are particularly deep in the European retail sector. "People with a negative view of the credit cycle, or concerns about a particular sector, could find it attractive," he said.

Named Aura, the deal will trade across euro, U.S. dollar, Japanese yen and sterling and Merrill is issuing seven- and 10-year notes on the portfolio. It is being pitched to investors globally and European clients got their first glimpse of the transaction last week. Types of investors, the target notional and set cap percentages could not be determined, but the trade is expected to be priced next month. More details are expected in the coming weeks.

Credit players say similar trades have been discussed in the market, in which a single tranche references nth to default baskets, each representing a sector of the market. If a basket comprises 10 names, investors are exposed to a set number of defaults, say three, before it wipes out. Various officials said no such sector-specific deals have yet been issued.

  • 16 Sep 2005

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3 Bank of America Merrill Lynch 316,666.04 1099 8.03%
4 Goldman Sachs 236,643.87 789 6.00%
5 Barclays 230,494.28 891 5.85%

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Rank Lead Manager Amount $m No of issues Share %
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1 HSBC 34,591.50 163 6.58%
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3 Bank of America Merrill Lynch 31,293.04 95 5.96%
4 BNP Paribas 27,578.61 168 5.25%
5 SG Corporate & Investment Banking 23,982.83 136 4.56%

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4 UBS 15,487.17 60 6.95%
5 Goldman Sachs 14,053.61 76 6.30%