Daiwa Securities has launched the world's first public, rated collateralized equity obligations. So-called CEOs are being touted as the perfect solution for investors looking for a higher yielding alternative to collateralized debt obligations as CDOs are getting tougher to structure in an environment of tightening spreads and shrinking liquid credits.
It has long been thought that CEOs could fill the gap but few bankers thought there were sufficient investors comfortable enough to absorb a substantial deal. Most arrangers have therefore sought to soften attitudes and familiarize investors through hybrid deals, combining small equity portions with traditional CDO structures, or small deals placed with single investors. That tactic could be set to change with Daiwa's surprise deal, due for completion in late March.
The deal is structured similarly to a CDO, except that instead of referencing corporate debt through credit default swaps, a CEO references corporate equity through equity default swaps, which are derivatives transaction between two parties. Daiwa will issue ¥23.4 billion ($216 million) of bonds, split into three tranches of equity linked notes due 2008 and issued by Zest V, a special purpose vehicle.
Put simply, investors lose out on a CDO when the underlying companies default on their debts, but investors in a CEO lose out when the share price of the reference companies falls below a pre-determined price. So CEOs are riskier as a result, because the factors that can precipitate a collapse in share prices are much more varied and may have little or nothing to do with the company's financial health. Also, a stock exchange crash can hurt the share price of all companies on a single bourse, meaning that it is harder to diversify risk than it is with credit events, which tend to be more specific to particular industries.
"Equity default swaps have higher volatility so that's what you're using to get better yields," says Nick James at Daiwa Securities.
But bankers say that equity default swaps can be tailored to provide a similar risk profile to credit default swaps, except with much higher yields. The Daiwa deal is referenced to the equity default swaps of 30 blue-chip companies listed on the Nikkei. The trigger event is a 70% fall in their share price between March 22 and December 22 2008.
"All the back-testing that has been done shows that the probability of a knock-in is very similar to that of a credit-event," says Paul Cluley, a partner at Allen & Overy who advised on the structure.
This represents such a precipitous fall in the share price, particularly for large, blue-chip corporates, that it can be likened to a credit-linked transaction - that is to say, a collapse of this nature would probably only be triggered by the same kinds of problems that would lead a company to default on its borrowings too.
Daiwa's Zest V CEO references a portfolio with a notional value of ¥45 billion and is tranched into three classes. There are ¥6.3 billion of class-A notes, provisionally rated A3 by Moodys and with a subordination ratio of 56%; ¥8.1 billion of class-B notes with a rating of Baa2 and a subordination ratio of 38%; and ¥9 billion of class-C notes rated Ba2 with a subordination ratio of 18%.