Sophisticated synthetic investors are diversifying the reference obligations on which they buy protection because of fears about the high degree of portfolio overlap in synthetic CDOs. Market players say the majority of CDOs issued in Europe this year reference the same group of about 400-500 liquid names and a single default by one name in this group could trigger sharp rating downgrades across hundreds of CDOs. Investors are mitigating the overlap risk by compiling customized portfolios on which they then ask a bank to write protection.
Structuring officials at Morgan Stanley, Calyon and IXIS Corporate & Investment Bank have reported a pick up in the number of these reverse inquiry transactions issued this year. "Investors are increasingly developing their own models to choose names," said one official at European firm. Mathew Zola, managing director in structured credit at Morgan Stanley in London, said the trades are originated primarily by hedge funds. "Overlap is something they look for and differentiate when buying trades," he noted, adding reserve inquiry trades may have been exacerbated by low corporate bond issuance and spurred on by investors looking for yield in today's tight credit spread environment.
Miguel Ramos, managing partner at Washington Square Investment Management in London, said the key to diminishing overlap risk is to invest heavily in the research of underlying. "Some people are pitched a deal and look closely at the structure and the manager, but don't study the underlying portfolio," he said.
In a report on portfolio overlap issued last week, rating agency Standard and Poor's noted the three most popular corporates are referenced in 80% of European synthetic CDOs and the top 40 appear in 50%.