Synthetic CDOs Making Comeback as Yields Juiced

Derivatives that pool credit-default swaps to make magnified bets on corporate debt, popularized in the last credit bubble, are making a comeback as investors search farther afield for alternatives to bonds at record-low yields.

Citigroup Inc. is among banks that have sold as much as $1 billion of synthetic collateralized debt obligations this year, following $2 billion in all of 2012, according to estimates from the New York-based lender. Trading in so-called tranches of indexes that use a similar strategy to juice yields rose 61 percent in the past month.

Synthetic credit, which amplified the financial crisis five years ago, is enticing investors after corporate-bond yields dropped to less than half the 20-year average. By betting on the degree to which a group of companies will default, a CDO may pay relative yields of more than 5 percentage points, four times that of a typical credit-swaps transaction on similar debt.

“That’s a valid strategy for this part of the credit cycle: Don’t stretch on credit quality, but rather leverage your exposure to better-quality credit,” Ashish Shah, the head of global credit investment at New York-based AllianceBernstein LP, which oversees $256 billion in fixed-income assets, said in a telephone interview.

Pooling Swaps

New York-based Citigroup offered one synthetic CDO trade to hedge funds this year that pooled credit swaps insuring against defaults of 125 corporate borrowers, according to a person familiar with the pitch and a copy of a proposed portfolio obtained by Bloomberg News.

The investor would start bearing losses in the pool when they reached 5 percent and would be wiped out if losses exceeded 7 percent, getting paid at least 500 basis points annually for three years. A simple credit-swaps trade on the same companies would have paid at least 130 basis points, according to the marketing document.

Unlike many of the synthetic deals created during the market’s peak before 2008, the transaction pitched by Citigroup wasn’t to be sold to investors in the form of securities and wasn’t graded by ratings companies.

About $2 billion notional of similar trades were created last year and between $500 million and $1 billion in 2013, Mickey Bhatia, the head of structured credit at Citigroup, said in an interview. The trades average between $10 million and $30 million, he said, declining to comment on any specific transactions.

‘Desperate Search’

“Investors are in a desperate search for yield,” said David Knutson, a credit analyst at Legal & General Investment Management America. “CDO products offer incremental yield to plain-vanilla transactions.”

Elsewhere in credit markets, a benchmark gauge of corporate credit risk in the U.S. increased as banks, hedge funds and other money managers moved trades into a new version of the credit-default swaps index.

Series 20 of the Markit CDX North America Investment Grade Index, used to hedge against losses on company debt or to speculate on creditworthiness, traded at 89 basis points, or 9.2 basis points higher than Series 19 as of 11:24 a.m. in New York, according to prices compiled by Bloomberg. The new series should trade 9 basis points wider than the old benchmark, based on the cost of the individual credit-default swaps on companies in each index, according to JPMorgan Chase & Co. analysts.

Block, Genworth

New versions of Markit Group Ltd.’s indexes are created every six months. Companies are replaced if they no longer have appropriate credit grades, aren’t among the most actively traded borrowers or fail to meet other criteria. Block Financial LLC and Genworth Financial Inc. were added to the new version while Canadian Natural Resources Ltd. and CenturyLink Inc. were removed.

The credit-swaps index typically rises as investor confidence deteriorates and falls as it improves. The contracts pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt-market stress, decreased 1.7 basis points to 16.56 basis points as of 11:25 a.m. in New York. The measure narrows when investors favor assets such as corporate debt and widens when they seek the perceived safety of government securities.

Index Tranches

Bonds of Charlotte, North Carolina-based Bank of America Corp. are the most actively traded dollar-denominated corporate securities by dealers, accounting for 6.3 percent of the volume of dealer trades of $1 million or more as of 11:19 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Index tranches are sliced up according to risk, with some investors agreeing to insure against the first few defaults among the pool of companies. Most trades have been in the lower-ranked tranches, with maturities of one to three years and predominantly in the U.S. and Europe, Bhatia said.

“It’s to do with the macroeconomic view,” with more certainty in the near-term than out 10 years, as well as liquidity concerns about the ability to sell in the secondary market, he said.

Synthetic CDOs

Sales of bespoke synthetic CDOs are climbing after the market all but shut down during the financial crisis in 2008. After the amount of credit protection sold through CDOs in that period climbed to about $1 trillion, investors took losses of up to 90 percent on deals that bet heavily on financial firms that failed during the crisis, including Lehman Brothers Holdings Inc. and Icelandic banks.

In the mortgage market, CDOs that packaged home-loan securities and were given top AAA ratings by S&P wiped out investors in a matter of months, according to a lawsuit by the Justice Department filed Feb. 4 in Los Angeles.

Synthetic CDOs “enabled securitization to continue and expand even as the mortgage market dried up and provided speculators with a means of betting on the housing market,” the Financial Crisis Inquiry Committee wrote in a 2012 report. “By layering on correlated risk, they spread and amplified exposure to losses when the housing market collapsed.”

As the Federal Reserve holds its benchmark interest rate near zero for a fifth year, investors including pension funds and hedge funds are again seeking out more structured debt or derivatives that offer greater yields than the bonds or loans underlying them.

Yield Alternatives

Average yields on investment-grade corporate bonds dropped to 2.82 percent on March 18, 3.16 percentage points below the average since 1993, according to the Bank of America Merrill Lynch U.S. Corporate Index. Yields have fallen from a record 9.3 percent in October 2008, the month after Lehman Brothers filed for bankruptcy.

Sales of collateralized loan obligations, which pool together the senior secured debt of speculative-grade companies, surged more than fourfold last year to $55 billion, according to data compiled by Bloomberg. Bank of America expects $75 billion to be created this year.

In the index tranche market, the simplest form of a synthetic CDO where investors bet on the degree to which companies in credit-swaps benchmarks will default, trading also is increasing.

MBIA, Radian

Net outstanding contracts on tranches of the current version of the Markit CDX investment-grade index climbed to $1.48 billion in the week ended March 15, from $919 million a month earlier, according to the Depository Trust & Clearing Corp., which runs a central repository for the market. The market has expanded 71 percent in the past year.

By comparison, tranche trades on Series 9 of the index, created in September 2007 when the synthetic CDO market was near its peak, have dropped 42 percent to $37.2 billion. Series 9 of the index is tied to 121 companies, all of which were investment grade at the time, including Armonk, New York-based MBIA Inc.’s now junk-rated MBIA Insurance Corp. unit and Philadelphia-based Radian Group Inc.

Trading in synthetic CDOs will continue to rebound even after global bank capital rules and the U.S. Dodd-Frank Act make derivatives more expensive to trade and hold, Peter Tchir, founder of New York-based TF Market Advisors, said in a March 15 e-mail to clients.

“There’s going to be this bigger search for yield and spread, and tranches are a natural way to do it,” he said.