Asia is poised for a boom in business in collateralised debt obligations (CDOs) - portfolios of debt and derivatives - as innovative new products entice investors and as banks seek to manage their balance sheets.
CDOs come in all shapes and sizes and are often created based on specific circumstances, such as what assets a bank has on its books, what its balance sheet looks like or what pockets of demand a CDO originator is aware of.
But broadly speaking, CDOs can be classified based on their underlying assets - cash or synthetic - and on why they have been created - balance sheet management or an arbitrage opportunity.
"The Asian market is dominated by synthetic arbitrage CDOs. But an increasing trend in the past 12 months has been the interest in creating balance sheet CDOs," said Peter Eastham, director of structured finance for Standard & Poor's.
To date, synthetic CDOs have been preferred in Asia, bankers say. It is easier to create one because they are generally based on more liquid assets such as credit default swaps (CDS).
A CDS contract is an insurance-like derivative that offers the buyer compensation in the event of a default. In exchange, the buyer pays a premium to the firm that sells the CDS.
"Synthetic CDOs generate volumes because they are quicker to arrange than cash deals and created on a bespoke basis and so are tailored for investor preference," said Rachel Hardee, head of Asia-Pacific structured credit at Fitch Ratings.
CDOs often are created when banks have assets on their books, such as loans they have made or bonds they have bought, for which they have to set aside a lot of capital.
There are risks to the value of these assets in case of defaults, so banks - under so-called Basel II regulations that are designed to ensure the banking system is healthy - are required to set aside capital just in case. By creating a CDO and passing on the risk to the CDO buyer, a bank can free up capital and put it to use.
Hardee said increasingly synthetic CDO deals were being struck to adjust levels of risk on balance sheets.
"This may be motivated by Basel II and a desire to employ economic capital more efficiently," she said. The Bond Market Association Web site says second-quarter CDO issuance rose to $89.5 billion from $60.6 billion a year earlier, a 48 percent increase. But the figures do not include a breakdown for Asia volumes and bankers say the Asia outlook is based on anecdotal evidence.
Yield spreads - the difference between higher-yielding securities and top-rated government bonds - have been declining lately as investors show more appetite for risk. One measure is the iTraxx credit default swaps index It has fallen to 51.5/53 basis points (bps) from the end-June level of 64 bps.
"Although CDO tranches are not paying as much as before they are yielding higher than single credits or single ABSs (asset-backed securities)," said Pierre Trecourt, head of Asia-Pacific structured credit and CDOs at Calyon Corporate & Investment Bank.
Cedric Podevin, head of credit derivatives structuring, Asia Pacific, at BNP Paribas, said that as yield spreads have shrunk, new products have become popular.
"We see new entrants, new products for yield enhancements," Podevin said. One example: CDOs that offer investors a "long/short" strategy.
In May, WestLB London launched a CDO which was structured to take advantage of any higher spreads on insuring debt taken by companies prone to leveraged buyouts. In a traditional synthetic CDO, the investor has a "long only" strategy, which takes advantage of falling spreads, ie gains rather than losses in the underlying assets.
"CDO volumes have continued to rise over the past few years, bearing testimony to the fact that investors have not stayed on the sidelines despite tighter credit spreads," said Chandrakant Mohanty, head of Pacific Rim Structured Credit Products, Merrill Lynch.
"Instead, they have become more creative and look for innovative structures, using for example, the long/short strategy, doing combo notes or by taking on more leverage on higher-rated portfolios." CDOs are also increasingly seen as a way to gain exposure to assets that otherwise are hard to invest in.
"Cash CDO investors in Asia have long recognised that one of the best ways to invest in esoteric asset classes such as US and European leveraged loans and ABS is to outsource it to experienced top tier CDO managers with proven track records," said James Lee, head of structured credit products, Asia at Citigroup.
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