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Derivatives

Fund Managers Look To CDOs To Give Guaranteed Products A Bigger Kick

Asset managers are looking into structuring capital guaranteed products with credit derivatives and collateralized debt obligations--rather than zero-coupon bonds--to leave more capital available to purchase options, offering investors more upside participation. Andrew Irvine, head of structured investment products at Investec Financial Products, said it is considering producing such a product.

The capital guarantee is usually provided by a zero-coupon bond and then the participation comes via a long call option position. The low interest rate environment has driven up the price of zero-coupon bonds, leaving less to spend on the option. By using either a CDO or a credit-default swap to provide the guarantee, the yield would be higher and would allow the structurer to purchase an option with a higher delta, noted Johan Groothaert, global head of structured products in equity derivatives at Deutsche Bank. Irvine said would it would likely use the A to AAA tranches for the guarantee.

Capital guaranteed products using CDOs or default swaps could interest either institutional investors or sophisticated high-net-worth individuals.Mike Chadney, head of structured products and derivatives at Henderson Global Investors in London, said for a sophisticated investor this is a strategy worth considering.

Asset managers pointed out, however, that such a product would be difficult to sell into the U.K. retail market. John McLaughlin, head of structured investments at Schroder Investment Management said, "I doubt that anyone who is not a financial professional would properly understand a CDO or CDS." Chadney agreed, noting that retail investors are really looking for clarity.

Groothaert said some investors are becoming interested in using credit derivatives as part of the capital guarantee but doesn't think it will become widespread amongst retail and private investors.

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