Constant proportion debt obligation dealers and index tranche traders are beginning to plot strategies for the March 20 roll of the CDX and iTraxx credit derivative indices.
CPDOs, which deploy leveraged exposure to these indices, will be forced to roll positions into less-risky on-the-run indices every six months for the life of the deal as a criterion for their high ratings. The effect of all CPDOs attempting to buy protection on soon-to-be off-the-run indices and selling protection on new on-the-run indices in a short and predetermined timeframe will push spreads wider on the old indices. This technical effect will balance the traditional dynamic of investors, such as bank loan books putting on the opposite trade of selling protection on the old index and buying protection on the new index. This will also create relative-value opportunities for index traders, who already are thinking about pre-positioning for the roll.
"If I know all these CPDOs are going to have to buy protection on the old index before it rolls, I'm going to drive out spreads in the days before the roll," said one trader, adding traders also would drive spreads tighter on the new indices. Excessive spread widening on off-the-run indices in the run-up to the roll could create mark-to-market losses for CPDOs. This could be compounded by spread tightening in new indices, which would deny CPDOs a sufficient carry to compensate for MTM losses. Traders pointed to the roll from CDX.IG.4, which contained downgraded auto companies General Motors and Ford Motor Co., into IG.5 as an example of negative carry.
One credit structurer said CPDO issuers might anticipate index traders' strategies and pre-position against their pre-positioning. "It's game theory," he said, but noted that could backfire. Strategists said dealers might also try to cap spread widening or put on curve steepeners.
Although CPDO issuance is likely to be light through the end of the year, about 15 deals are planned for January and issuers are looking at enlisting managers to add flexibility around the roll date. "Managers will add value by being able to time the execution and reduce the roll cost," said one European credit manager.
