An Investor's Guide To Asset Management Synthetic CDOs

Asset management (or managed) synthetic CDOs effectively securitize investment-grade corporate credit risk. A managed synthetic CDO combines the structure of a traditional asset management cash flow CDO with the cost-effective risk transfer of a static synthetic CDO. The result is a portfolio credit product that provides investors with an efficient investment strategy in an actively managed, diversified pool of investment-grade corporate credit. The advantage of managed synthetic CDOs for investors is the same as it is for other actively managed CDO products: a tailored exposure to an expert manager's performance in the selected asset class. Although the market has not yet converged on a standard managed synthetic CDO structure, the broad characteristics have been established.

 

Structure

The guiding principle of CDO structuring is to provide equity investors with the highest and most stable return profile while minimizing the risk of the CDO debt classes. As with other actively managed CDO products, managed synthetic CDOs are constructed to provide the manager with flexibility while protecting the CDO debt investors. Since equity investors own a leveraged position in the ability of the sponsoring manager to generate high risk-adjusted returns, the structure of the CDO aims to give the manager maximum freedom to focus on credit selection and total-return performance without being unduly restricted. At the same time, a managed synthetic CDO protects debt investors by increasing credit enhancement in response to credit losses, and by limiting the manager's trading discretion in troubled transactions.

The diagram shows the structure of a typical asset management synthetic CDO. The synthetic CDO issues senior and mezzanine notes as well as equity and enters into a super-senior swap. The note and equity proceeds are invested in high quality, liquid eligible collateral. The CDO also sells protection on a portfolio of credit-default swaps in the single-name default swap market. The default-swap portfolio references primarily single A and BBB rated corporate credits. The premiums on the default swaps combined with the interest from the eligible collateral provide the interest income of the CDO.

The issued notes and super senior swap typically have a final maturity of five to 10 years, with seven or eight years usually being optimal. The transaction is structured as a bullet, with the possibility of a several-month-long extension to work out late-occurring credit events. The sponsoring manager selects the initial default-swap portfolio and conducts trades to minimize credit losses and maximize total returns. In return for managing the portfolio, the manager receives a periodic fee from the CDO. The super-senior swap counterparty receives a periodic swap premium, while the note holders collect a coupon. As with cash flow managed CDOs, equity investors receive the excess spread: specifically, the income received on the underlying single-name default swap positions plus the interest on the eligible collateral minus the costs of the liabilities and transaction fees. Equity investors usually have the option to call the transaction after a lock-out period of several years.

Credit events affecting the reference entities in the default-swap portfolio trigger settlement of the contracts. Currently, there is no standard in managed synthetic CDOs for physical versus cash settlement of triggered default swaps, although physical settlement is by far the most common contract type in the single-name market. In the example transaction, we assume physical settlement. After a contract triggers, the default swap counterparty delivers an eligible obligation to the CDO and receives par in return. The CDO manager decides on the optimal workout strategy for delivered obligations and may hold them for one or two years. In cash-settled structures, the CDO pays the default swap counterparty in a triggered contract the difference between par and a valuation of the reference obligation. Funds used to settle triggered default swap contracts initially come from the sale of the liquid eligible collateral held by the CDO. The super senior swap counterparty is not called to make payments until all of the collateral, including delivered obligations, has been used to settle single-name default swap claims.

The current standard default swap credit events in the U.S. include bankruptcy, failure to pay, and modified restructuring. To the extent that default swap credit events do not match the default definition used for historical default studies, the rating agencies stress the default and recovery rate assumptions for the managed synthetic CDO rating process. If the market convention for default swap credit events changes, the synthetic CDO template contracts can adapt as long as the rating agencies and the super senior swap counterparty approve the change.

Managed synthetic CDO debt investors are protected, in part, by quality and coverage tests. Quality tests specify limits on the portfolio characteristics, such as diversity score, rating and the weighted average spread of the default swaps. To provide the manager with flexibility in selecting credits, the portfolio quality limits are more conservative than the expected values. The extra room in the portfolio quality tests improves the rating stability of the CDO liabilities. The average rating quality of the portfolio is expected to be Baa2/BBB, while the limit is Baa3/BBB minus.

Unlike most static synthetic CDOs, managed synthetic CDOs employ coverage tests to improve both the economics of the equity class and the rating stability of the notes. Managed synthetic CDO debt investors are protected by coverage tests from unexpectedly large default swap portfolio credit losses. The extra protection enjoyed by the debt investors allows equity investors to achieve higher leverage. Coverage test values are computed by dividing the notional of the eligible collateral by the outstanding notional of the corresponding debt notes and all notes senior to it. For example, the AA coverage test value is the ratio of the eligible collateral and the sum of the notionals of the AA and AAA notes. Unlike cash flow CDO coverage tests, which when triggered de-lever the transaction by repaying the liabilities early, managed synthetic CDO coverage tests increase the credit enhancement of all liabilities by trapping and reinvesting the excess spread in additional eligible collateral.

The table displays the capital structure of a hypothetical managed synthetic CDO. In this example transaction, the weighted average cost of liabilities is 15-18 basis points per annum. The efficiency of the managed synthetic CDO capital structure is due to the large super senior class, which is often distributed at a cost of 8-10bps per annum. By contrast, consider a version of the capital structure in table 1 that issues the AAA and the super senior classes as a single large AAA note. Even assuming a lower spread on a larger AAA note of 40basis points per annum, the total liability cost of the cash structure would more than double relative to the synthetic structure to 43bps per annum. At this liability cost, the structure becomes uneconomical for the equity investors.

Conclusion

The asset management synthetic CDO has evolved from established CDO structures--managed cash flow and static synthetic CDOs--to become the most efficient vehicle for securitizing an actively managed portfolio of investment-grade corporate risk. In 2001, seven actively managed synthetic CDOs priced with a total dollar notional of USD7.24 billion. We expect that in 2002, at least 10 and possibly as many as 15 managed synthetic CDOs of approximately USD1 billion each will reach investors.

Although the market has not yet converged on a standard managed synthetic CDO structure, several key features are now apparent. The chief among them is the low cost of transferring the single-name credit risk to the portfolio credit investor market. The low-risk transfer cost enjoyed by managed synthetic CDOs contrasts with cash flow investment-grade corporate bond CDOs, which transfer the entire risk in funded, and therefore more expensive, form. Most early and contemporary structures employ the super senior portfolio default swap market to distribute the large senior portion of the default swap portfolio risk economically. Some newer structures, however, dispense with the super senior swap altogether, since the single-name default swap counterparties to the managed synthetic CDO are often willing to bear this extremely remote risk.

We expect a period of intense innovation in the structure of managed synthetic CDOs. As the underlying default swap market continues to grow, the managed synthetic CDO structures will evolve alongside it. For example, the development of the high-yield default swap sector as it catches up in breadth and liquidity with the investment-grade market will result in the emergence of high yield managed synthetic CDOs. Managed synthetic CDOs will also evolve to allow managers to take advantage of new investment strategies emerging in the single-name default swap market. Finally, although the basic terms of the default swap contract have stabilized for now, any changes in terms will be reflected in the managed synthetic CDO structure.  

This week's Learning Curve was written by Alex Reyfman, v.p. in credit derivatives strategies in New York, and Klaus Toft, v.p. in credit derivatives strategies at Goldman Sachs in London.