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Derivatives

Portfolio Overlap Fears Lead To Diversification Push

Widespread trepidation about portfolio overlap in synthetic collateralized debt obligations prompted dealers to source more diversified underlyings this year, a trend likely to continue into next.

Widespread trepidation about portfolio overlap in synthetic collateralized debt obligations prompted dealers to source more diversified underlyings this year, a trend likely to continue into next. This year has seen a concerted effort to increase diversification in CDO portfolios by referencing different asset classes. One manifestation has been the rapid growth of the synthetic asset-backed securities CDO.

The tight credit spread environment has also fuelled demand for diversification to boost yields, with emerging market credits gaining popularity this year (DW, 8/26). Katrien van Acoloyen, structured finance analyst at Standard & Poor's in London, noted a sharp increase in the number of synthetic emerging market CDOs rated by the agency this year, up to 21 from four in 2004, according to a report published this month. Interest in emerging market CDOs will increase because they offer a more attractive yield and there is improved liquidity in credit-default swaps linked to emerging-markets, Acoloyen said.

The first synthetic CDOs referencing public finance assets hit the market this quarter (DW, 12/19) and further diversification into commodities and fx is likely, said one structurer at a U.S. house in London. One marketer at a European firm said synthetic investors will opt for managed CDOs next year, particularly on portfolios with high yield or illiquid assets. He also predicted end-users will prefer single asset-class transactions. "They want simplicity and will steer clear of portfolio mish mash," he said.

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