Asian investors warming to synthetic CDOs

Recent deal by Lehman Brothers and PCI Investment Management suggests arbitrage synthetics have a future in the region.

Although the Asian securitization market has shown marked signs of sophistication in the past couple of years, the synthetic business - especially for arbitrage transactions - has yet to take off in the way most experts had hoped. There are good reasons for that, many related to supply-side issues, but perhaps the critical factor was that Asian investors were not convinced about the merits of arbitrage synthetic deals.

A case in point was the $121.5 million Spectra 1 transaction that ING and OUB Asset Management tried to issue in November 2001. Backed by a portfolio of $450 million of credit default swaps (CDS), the deal offered yields ranging from 45bp over three month Libor on the triple-A notes to 275bp on the Baa3 junior tranche.

Ultimately, ING pulled the deal, citing poor investor sentiment following 9/11 and the fallout from the Enron corporate scandal. Bankers not involved in the transaction gave other explanations for the failure to get the deal done - namely that Asian investors were not keen on bonds that were not collateralized by physical assets, especially not at the spreads that were offered.

Seemingly, a year can make a big difference in the minds of investors - with first Deutsche Bank and United Overseas Bank putting together a $106.4 million deal backed by CDS in September, and at the back end of November, Lehman Brothers working with PCI Investment Management to issue a $63.25 million transaction backed by $500 million of CDS.

Lehman's and PCI's deal - issued out of the Asia IG CDO Ltd special purpose vehicle, registered in the Cayman Islands - securitizes credit default swaps with 100 investment grade companies, with an average rating of Baa1.

Where the Lehman-led transaction really differed from what has gone before in Asia - aside from being the first deal to involve a Hong Kong-based asset manager - was that most of the reference entities - 62% - included in the portfolio were from the Asia Pacific region. Previously, the limited size of the credit default swaps market in Asia necessitated that most of the reference entities in such deals would have to come from Europe or the United States. Some felt that it would be hard to sell deals in Asia that included names with which investors were not so familiar.

"The deal is important because the underlying portfolio is mostly made up of Asian reference entities and the fact that all those are investment grade sets a good example for the market," says Jerome Cheng, a senior analyst and vice president of structured finance at Moody's. "As the Asian CDS market has matured and become more liquid, this has laid the foundation for the development of arbitrage synthetic CDOs. The credit spreads of the underlying reference entities also provide a reasonable arbitrage window from time to time. This is of the utmost importance to a successful synthetic CDO deal."

Lehman acknowledged that as arbitrage CDOs are still a new product to investors, the yield pick up would need to take that into account. Consequently, the spreads on the five-year $33.25 million senior A notes - rated Aaa by Moody's, was 65bp plus Libor, and 120bp for the Aa2-rated $22.5 million B tranche. Pricing on the $17.5 million C tranche was undisclosed.

According to a source close to the deal, 6 investors participated in the transaction with interest mainly coming from banks and insurance companies. "You do not see a lot of arbitrage CDOs in this market, so you have to be a market taker," says the source. "You set pricing at wherever the lead client order is. The market is still in its early stages here, but investors that are active in the CDS market will be repeat buyers of this type of product."

"It all depends on how the CDS market evolves in Asia and the region is at the stage which Europe was about five years ago," the source adds. "Europe's market really took off because banks active in the loan syndication business - which is essentially a loss leader - found that they were able to move credit default risk off their books through CDS. That is starting to happen in Asia and as it grows, the arbitrage CDO market will become much more active as well."

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