Collateralized debt obligations referenced to equity-default swaps are likely to remain a niche market because structurers won't be able to get the ratings required to make them saleable to mainstream investors.
Martin Bertsch, head of financial engineering at JPMorgan in London, said selling the products to a wide institutional investor client base would require a good credit rating. Without the rating the deals are likely to be confined to the most sophisticated and flexible investors, such as high-net-worth individuals and hedge funds. JPMorgan recently launched the first CDO with equity-default swaps in the portfolio, but they only accounted for 10% of deal.
Perry Inglis, co-head of the operating vehicle group at Standard & Poor's in London, estimated that a reference portfolio consisting only of equity-default swaps would require 70-80% subordination to get a triple-A rating. In comparison, triple-A notes on CDOs referenced to investment-grade credit-default swaps have subordination levels of 5-10%.
"In current market conditions, it is difficult, if not impossible, to assign a triple-A rating to a tranche of pure EDS," according to Paul Mazataud, managing director in the CDO group at Moody's Investors Service in Paris. This is likely to mean that the deals will not take off as well as many bankers predict.
Moody's has finalized its ratings methodology for CDOs of EDS, but according to Mazataud bankers and managers may prefer CDOs exposed to mixed portfolios of CDS and EDS, which can be assigned higher ratings. Moody's rating methodology takes into account three different states of the market: normal, stressed and crash. Mazataud explained that despite the equity market bubble bursting in 2000 and major shocks now looking unlikely because equity valuations are lower, the equity markets need to recover more before it can assign triple-A ratings to equity-linked products.
Bankers and managers, however, are still interested in trying to structure the deals. Robeco Alternative Investments is talking to rating agencies about a single tranche CDO with 100% EDS. "We have seen demand from investors for this kind of product," said Edwin Noomen, v.p. in Rotterdam. Rating agency staff are also predicting a flurry of deals as structurers look for ways to increase yield (DW, 2/9.
