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Derivatives

CDO Investors Look At Hedging Spread Risk

Collateralized debt obligation spreads are now so tight some investors are looking at shorting CDO tranches to hedge spread risk in both CDOs and wider credit portfolios.

Collateralized debt obligation spreads are now so tight some investors are looking at shorting CDO tranches to hedge spread risk in both CDOs and wider credit portfolios. One trade banks are starting to pitch to investors is to buy the junior mezzanine tranche of a CDO and simultaneously sell the senior tranche. This still gives investors a coupon, but softens the impact of spread widening.

Barclays Capital published a research report last week in which it said, "Given where credit valuations are, we recommend that investors consider ways of hedging downside credit risk in their portfolios." It proposes buying tranched protection referenced to the iTraxx credit derivatives indices.

Birgit Specht, head of securitization and structured credit research at Dresdner Kleinwort Wasserstein in London, said there is still some tightening potential in structured finance over the next couple of months, but she is recommending investors adopt a defensive attitude. Specht believes defensive deals and those with good managers and flexible structures will widen the least if credit spreads do widen.

But, not everyone agrees spreads are set to widen. Rick Watson, managing director and head of structured finance at FGIC UK in London, said, "We don't see spreads widening." He added, "Unless you see a fundamental recession there is too much money slopping around looking for assets."

Anthony Morris, director in structured fixed income at UBS in London, said, "You can't have wider spreads if corporates can't default and at the moment most corporates are flooded with cash." That could change, however, because corporates are starting to relever their balance sheets and cash-funded M&A would quickly burn through that cash.

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