What are CPDOs?
A CPDO, or Constant Proportion Debt Obligation, is an incredibly complex credit investment strategy. It generates high coupon payment through dynamically leveraging a position in an underlying portfolio of index default swaps. These obligations allow investors to seek high yields, comparable to the ones of junk bonds. They bear a low investment risk proportional to the default risk of high investment grade bonds. The first CPDO was developed in April 2006 by the Dutch credit institute ABN Amro.
These obligations were incredibly complex and used leverage to provide a return for the investors above the average 90 days bank bill swap rate. During that same year, the Dutch bank asked rating agencies to evaluate these financial products: both S&P and Moody’s responded to the call. For those two agencies the rating of the obligation was AAA, a decision that caused great controversies in the financial world.
The functioning of CPDOs
A CPDO is made of two positions, a long one in the money market (consisting of short-term investments) and one composed of indexed default swaps on indexes like ITRAXX and DJ CDX. This type of obligation dynamically adjusts the leverage structure and its risk exposure. In doing so it ensures that revenues arising from the two positions will balance the promised customer coupon payments and all the expenditure and losses.
The functioning of CPDOs is mainly based on two agents: an investor and a CPDO manager. Initially, the investor injects capital in order to receive periodical coupons payments until the end of the contract of an agreed spread over the LIBOR rate. The manager utilises these funds (that investors place in the CPDO) and invests them in leverage selling protections on the mentioned credit indexes, through default swaps. Regardless of the outcome, the CPDO portfolio can either cash in or cash out.
The event of cashing in is favourable to the investor and to the CPDO itself. It represents the situation in which the portfolio reaches a value that is sufficient to meet all future liabilities before the end of the contact. In this case, the funds will be invested only in short-term positions in the money market and all swap contract will be liquidated. Instead, if the CPDO cashes out, the value of the portfolio plunges below a certain threshold k (of the investor’s initial placement).
As a result the CPDO lays out all the risky exposure, in order to return all the remaining to the investors, without further payment of coupons.
The leverage structure
A CPDO is a structure credit product where the proceeds received by investors are utilised as a collateral for a long position in a CDS portfolio. The notional of this position in CDS does not match with the amount collected but it is geared up by a factor m that is the leverage factor of the CPDO. This leverage is adjusted dynamically during the lifetime of the CPDO, every six months and whenever there is a default in the underlying index name.
The name of this special obligation specifically arise from this leverage structure as it is piecewise constant. Following this the name “constant proportion” debt obligation CPDO was pinned on. We can state that CPDOs have a strategy that will lead to an increase in the leverage in case of loss and a decrease in case of gains. This is a” Buy low and sell high strategy” .
Simplification of cash flow structure
After inception, during the lifetime of the CPDO there are many subsequent cash flows that can be decomposed and analyse part by part. On any date before maturity the CPDO will:
- Receive interest payments from the money market account on the notional invested.
- Pay coupon corresponding to the Libor plus spread negotiated with investors at inception.
- Pay default losses to the owner of the swap contracts arising from default of one or more names in the ITRAXX or DJ CDX indices.
- Receive income arising from spread.
- liquidate swap contracts.
It is clear that it is quite complex to analyse this product’s cash flows without a deeper analysis. For now we will just simplify the article and report the facts, without a deeper financial analysis.
The factor of risks
It is difficult to assess the factor of risk that would spark a cash out situation or simply the impossibility to return par at maturity. However it is feasible to delineate some main factors that can be reconnected to the following macro-areas:
- Spread risk: Since the index default swap spread is the main component of the cash flow of CPSOs and its evolution in time has effects on the swap income and on the profit or loss arising from roll and rebalancing dates. A sudden change in the spread will generate two main effects. On roll dates a change in spread will generate a change in a single cash flow, but it will also have an effect on long term spread income. It is still not clear and in depth analysis are needed in order to asses which effect will dominate.
- Default risk: The number of defaults in the names of the underlying portfolio is expressed through the default rate. A higher rate is not detrimental for the CPDO as it leads to higher expected credit losses.
- Interest rate risk: The term structure of interest rates influences the cash flows of the CPDO through LIBOR, as the higher the LIBOR rate the higher the coupon payments that this product will promise to investors, and through the discount factor used in the calculation of the present value.
- Liquidity risk: Since the cash flow of CPDOs are also affected by the bid/ask spread of the index, an important factor of risk is the liquidity of the index default swap.
The power of Rating agencies
Having defined what CPDOs are and how the function, based on leverage and a “Buy low and sell high strategy”, the main controversial since the first appearance on the market has been their ratings. The models proposed by S&P and its AAA rating have been highly criticised and also judged misleading and unfair (losses arised from CPDOs in Australia amounted to 16.6 Millions) from the Australian Supreme court. The fact that a minimal change in some arbitrary parameters could alterate the rating from AAA to BBB is at the center of this discussion. Hence I would like to conclude this article with a question for all of the readers:
In such a situation, where challenging investment products are analysed, is it correct and sufficient to rely merely on the judgment of rating agencies? Or there should there be a common regulatory board or agency, that has the power to analyse the risk structure independently?