Tighter credit spreads in European bonds will result in more synthetic collateralized debt obligations as arbitrage gets harder. Paul Varotsis, head of CDOs at Barclays Capital in London, argues that synthetics offer better arbitrage opportunities than cash CDOs, as well as cheaper funding. Synthetic transactions already outnumber cash flow transactions in Europe by five to one and Varotsis expects this gap will widen. "When we had the arbitrage [in 2003], we didn't have the investors. Now, we have the investors but arbitrage is much tougher," says Varotsis. He adds: "There is no problem that good engineering can't resolve."
Higher bond prices make sourcing collateral more difficult for CDO structurers, adding to the appeal of packaging synthetic assets.
Further, Varotsis does not expect to see any more CDOs backed by unsecured corporate debt of any kind, cash or synthetic, because of the tighter spreads in both markets. He predicts that the final curtain has dropped on these deals, which include the likes of Axa Investment Managers' E3 billion Overture deal, which was sold last year. Whereas that deal had a target spread of 115 basis points over EURIBOR, he says 70 basis points is more typical now. "In today's environment, it is far harder to squeeze in the spread," Varotsis notes.