Synthetic CDOs Making Comeback as Yields Juiced: Credit Markets

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March 20 (Bloomberg) -- 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.

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 gauge of debt-market stress in the U.S. jumped to the highest in almost seven months as European policy makers struggled to forge a bailout plan for Cyprus. Bank of America Corp. raised $4 billion in a four-part bond offering. Apollo Global Management LLC’s CKE Restaurants Inc., the parent of Carl’s Jr. and Hardee’s, is marketing $1.05 billion of bonds linked to the company’s assets.

The U.S. two-year interest-rate swap spread increased 3.1 basis points to 18.2 basis points, the highest Aug. 23. The measure widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate bonds.

Protestors cheered outside the parliament in the Cypriot capital, Nicosia, as lawmakers voted 36 against to none in favor of the rescue proposal. There were 19 abstentions. Hammered out by euro-area finance chiefs, the deal sought to raise 5.8 billion euros ($7.5 billion) by drawing funds from Cyprus bank accounts in return for 10 billion euros in external aid.

Credit Benchmarks

The cost of protecting corporate bonds from default in the U.S. rose for a third day from a three-year low. The Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, added 1.5 basis points to a mid-price of 81.9 basis points, according to prices compiled by Bloomberg. The index ended March 14 at the least since Jan. 11, 2010.

In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings added 6 to 114.8.

Both indexes typically rise as investor confidence deteriorates and fall as it improves. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Bonds of Charlotte, North Carolina-based Bank of America were the most actively traded dollar-denominated corporate securities by dealers yesterday, accounting for 6.7 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

BofA Offering

The second-largest U.S. lender sold $1 billion of five-year notes that yield 107 basis points more than the three-month London interbank offered rate and $750 million of three-year debt at 82 basis points over the benchmark, according to data compiled by Bloomberg.

The bank also added on $1 billion to its 2 percent bonds maturing in January 2018 that pay 122 basis points more than similar-maturity Treasuries and sold $1.25 billion more of its 3.3 percent securities due January 2023 at 147 basis points.

Libor, the rate at which banks say they can borrow from one another, is the standard for about $360 trillion of financial products.

CKE’s offering, which will be backed by assets including franchise fees, is the company’s first so-called whole-business deal, according to a person familiar with the transaction, who asked not to be identified because terms aren’t public. Barclays Plc is arranging the sale for the Carpinteria, California-based company.

Leveraged Loans

Companies have sold about $50 billion in bonds tied to consumer and business borrowing this year, with deals linked to unusual collateral such as franchisee fees, wireless cellphone towers and timeshare payments poised to climb.

The Standard & Poor’s/LSTA U.S. Leveraged Loan 100 Index fell 0.02 cent to 98.14 cents on the dollar, The measure, which tracks the 100 largest dollar-denominated first-lien leveraged loans, reached 98.17 on March 14, the highest since July 2007, and has returned 1.84 percent this year.

Leveraged loans and high-yield, high-risk, or junk, bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- at S&P.

In emerging markets, relative yields climbed 7 basis points to 299 basis points, or 2.99 percentage points, according to JPMorgan’s EMBI Global index. The measure ended last year at 265.8.

The derivatives trades Citigroup has been marketing are so- called bespoke synthetic CDOs, where, unlike index tranches, the companies included vary from deal to deal.

Slicing Risk

The average annual premium paid by credit swaps in those deals have been between 100 and 150 basis points, said Citigroup’s Bhatia, as investors agree to wager on a riskier set of companies than in the benchmark indexes.

Series 19 of the Markit CDX investment-grade index this year has paid an average 86 basis points, prices compiled by Bloomberg show.

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.

Shut Down

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.”

Yield Alternatives

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.

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.

Tranche Growth

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.

--With assistance from Donal Griffin, Sridhar Natarajan, Charles Mead and Sarah Mulholland in New York. Editors: Shannon D. Harrington, Alan Goldstein