Constant roportion debt obligation (CPDO) -- CDS spreads sink to lowest levels
By Paul J Davies and Gillian Tett
Published: November 1 2006 21:06 | Last updated: November 1 2006 21:06
The cost of buying credit protection in the derivatives market has pushed through its lowest ever levels as bullish views on debt markets mix with a heavy bout of protection selling related to the creation of new structured products.
Spreads, or protection premiums, on the indices of credit default swaps, which provide a kind of insurance against the non-payment of corporate debt, have been shrinking steadily since the latest index series were launched at the end of September.
Some traders attribute this tightening of spreads, which has accelerated in recent weeks, to a benign economic outlook and a widespread belief that Federal Reserve tightening has peaked. But others point to the sudden growth of a new type of complex derivative product.
The iTraxx Crossover index of junk-rated companies hit an intra-day low of 243 basis points, meaning it cost €243,000 per year to insure €10m worth of exposure to the names in the index. The Crossover closed a touch wider at 244.5bp, but was down 2.5bp on the day.
The main iTraxx Europe index of investment grade companies also closed tighter at just over 23.5bp.
ABN Amro launched the first of the new products, known as a constant proportion debt obligation (CPDO), towards the end of August and it has since been rapidly replicated by a number of other large investment banks, including Merrill Lynch, Lehman Brothers and Barclays Capital.
These deals make leveraged bets on the European and US CDS indices and aim to build up returns to hit a certain pre-determined net asset value that will cover all the promised fixed coupon payments to investors.
However, if the market moves against the deal and it makes losses, then it must increase the leverage it employs to try and improve returns and hit its NAV target.
In a report on the structures out on Wednesday, Standard & Poor’s warned that this strategy could be viewed as “chasing losses”.
It is difficult to track exactly how much influence these new structures are having on the opaque over-the-counter CDS markets, but traders say they are definitely a factor.
“CPDOs printing are certainly a factor and a big one, but not the only factor,” said Haider Ali, global co-head of integrated credit trading at ABN Amro. “The economic environment is still good, equities are doing well and there is very little reason for anyone to buy protection.” |
