Credit officials predict writing capital protection on the equity tranche of collateralized debt obligations will be the next generation of credit structuring. Several houses have started pitching deals to private banks, which use constant proportion portfolio insurance to protect the investors' capital.
Julius Baer is one private bank which has talked to derivatives houses about CPPI on CDO equity. Yoshiki Ohmura, head of alternative risk trading in Switzerland, said, "I think this is where development is heading." Ohmura said Julius Baer does not have the investors for these products yet, but is interested because tight spreads mean investors looking for returns will start considering investing lower down the credit curve or increasing their leverage. A CDO equity note with capital protection could be a good solution for these investors, he explained.
CPPI works by dividing assets between a cash deposit and leveraging the remainder for investment in the target underlying, if the value of the CDO equity falls the protection provider will move capital from the CDO equity into cash. CPPI on CDO equity is attractive because it is a way of leveraging while giving principal protection, explained one credit structurer.
But some credit structurers say the equity tranche of CDOs is not liquid enough for constant proportion portfolio insurance. The high probability of the structure only returning capital means it is not suitable for a wide range of investors. Andrew Feachem, credit derivatives marketer in ABN AMRO, said the Dutch house has looked at CPPI on CDO equity but decided not to go ahead with any deals in the near future. The equity tranche of a CDO is not as liquid as credit index-linked portfolios, for example. This means trading costs when the portfolio is rebalanced would be high, he noted. An official at Barclays Capital, which is looking at CPPI on CDO equity but has not yet launched a deal, agreed a lack of liquidity is a barrier to structuring the notes. He added, however, "If we feel there's enough liquidity and transparency, we will structure the product."