Money managers in the U.S. are getting into constant proportion debt obligations--after spurning constant proportion portfolio insurance--because of a twist in the way the leverage is altered. Some dealers estimated that last week alone USD2 billion in CPDO notes were sold to institutional investors.
In both structures, investors' capital is leveraged and exposed to an asset such as the credit derivative indices. The mechanism for applying this leverage, however, is different. CPPI structures aim to protect investors' capital, so the leverage goes up when the asset is gaining value and decreases when the value of the asset falls. On a basic level, it is buying on the way up and selling on the way down. CPDOs, on the other hand, aim to protect investors' returns and do this by increasing leverage when the asset is not performing and reducing leverage when the asset is performing well. Cian Chandler, analyst at Standard & Poor's in London, noted the CPDO mechanism could be viewed as "chasing losses."
There is also some concern about the influence CPDO leverage-driven buying and selling may have on the underlying assets such as the credit indices. While most CPDOs are structured to absorb up to a 90% loss of net-asset value, ratings agencies are likely to downgrade deals if the credit environment weakens. Strategists explained this could in turn prompt a sell-off from ratings-based traditional money managers in the U.S. and buyers in the secondary market will be looking to bid at a discount. They may aggressively bid for investment-grade and iTraxx protection at the same time, both to depress the CDX and market price of these notes and to lock in an arbitrage against the underlying portfolio.
