Innovative ways of wrapping the first-loss piece of synthetic collateralized debt obligations are emerging as dealers race to tailor value-rich equity structures to investors' specific credit views. "We are all trying to come up with bespoke structures that will play on this," said one senior structured credit salesman.
Credit officials say appetite for equity risk is raging, driven by high levels of bespoke issuance in mezzanine tranches pumping up equity value. Sellers of mezz buy protection in equity to hedge exposure and this has injected value into the first-loss slice. "Being able to distribute equity risk is central to the business model of a correlation desk," said Lorenzo Isla, head of European structured credit strategy at Barclays Capital in London, who noted volumes in bespoke CDO equity tranches have doubled in the first quarter of the year. Hedge funds looking to boost returns are the biggest buyers of equity risk.
Tailored exposure started by coupling equity tranches with zero-coupon bonds, in which investors pay a small amount upfront and receive par at maturity, minus any credit events experienced (DW, 5/19). This has been further spurred by dealers tweaking the cash flows of this structure and splitting it into interest-only and principal-only pieces, which offers different exposure to defaults as well as both coupons and growth on principal invested. One salesman noted these are being sold on global underlying portfolios in sizes from EUR15-EUR50 million.
Other structures being pitched right now take a view on the timing of defaults. In a so-called all-running equity note, investors receive quarterly coupon payments on the outstanding notional of the first-loss tranche. Any defaults eat into coupon income and the investor must make default payments. Another variation, known as the all-upfront, pays investors a single coupon at inception, but they are still required to make payments or post collateral when there are defaults. A CDO trader said he had seen more interest in all-running than all-upfront, but that both were growing in volumes.
