Collateralized debt obligation houses including Bank of America, JPMorgan and Dresdner Kleinwort Wasserstein are working on creating a new market in options on CDOs. Tight spreads mean many investors are shying away from purchasing CDO tranches but still want exposure to the sector and bankers say options are the answer.
Mitchell Braselton, managing director and Europe, Middle East and Africa head of global structured products marketing for BofA in London, said clients can sell an option to enter a CDO struck at their desired spread level. If those spreads don't materialize the investors pocket the premium and walk away, but if spreads hit the strike the investors get into the trade at a level with which they are happy.
One investor said this is an excellent idea because it means counterparties can agree to all the documentation and reference entities and then just pull the trigger automatically when the economics work. He added that it enters these type of agreements informally anyway and this is just a way of getting paid for it. He cautioned, however, that a 12-month option on a five-year static CDO means the investor is taking exposure to a six-year deal and would have to be paid accordingly. This is compounded by the fact that most of the expected loss on these deals is at the back end of the trade.
Jonathan Slater, head of credit hybrid trading at JPMorgan in London, said this could turn into a reasonably large client market: it is just a question of fostering market interest. Sophisticated CDO investors are the natural targets, according to other bankers.
Another advantage of the product is that it puts the option sellers first in line for deals when the arbitrage appears. Darren Smith, co-head of CDOs at DrKW in London, said many investors think spreads have tightened too much and should widen, creating an arbitrage opportunity. But, with so many institutions watching the space, the arbitrage window is unlikely to be open for long. The options set both sides up for good execution, he added.
