I was very impressed by the length and quality of the flamewar discussion that emerged from my CPDO piece on Friday. Evidently, there are more than a few Economonitor readers who not only like to read about CPDOs on the weekend but who like to write about them as well!

One commenter, called Credit Guy – someone who is perfectly happy shorting bonds, it's worth noting – is very skeptical of the product, to the point that he almost comes out and says that the CPDO structure will break in the next down credit cycle. Here's his most substantive point:

These products are yet another example of the insane amount of levered short vol trades being put on at the top of the credit market... The problem is that the more you stretch the innovative new "leveraging product", the more you change/weaken the underlying collateral that goes into them, rendering the MODEL obsolete!!!!

I understand this criticism in theory, but in practice, how does the existence of CPDOs change the likelihood that US and European investment-grade corporates are going to default? Maybe CPDOs might drive down credit spreads by a basis point or two, but I can't see that having much impact on default rates.

More considered is jck of Alea, who worries about the maximum portfolio size preventing the CPDO recovering from spreads and volatilities spiking upwards. A friendly CPDO type explains the structure to him, however, and jck seems satisfied. Here's the explanation – remember that NAV stands for net asset value:

Let's take one of the simler structures on the markets as ana example. This has an absolute maximum leverage of 15x note notional (1500). there are, as you correctly pointed out, also other rules which tie the max leverage to NAV. In this example, the max leverage rule is min(1500, 25x NAV). At inception we are 15x leverage and value is 100. If value goes to 90 then max leverage is min(1500, 25x90) = min(1500,2250)=1500, thus there is no deleveraging yet. For 25x NAV to be less than 1500 (i.e. for a forced deleverage) the NAV has to be 60. Now, for the NAV to be 60 on day one, that is either 9-ish defaults with recovery at 30% or a spread widening of around 60bps (or a mixture of both defaults or spread widening). Once the NAV drops below 60, forced deleveraging occurs (i.e. effectively becomes CPPI with negative gamma). If NAV drops to 50 then CDS positions reduces to 1250, 40 implies 1000 etc. I think the important point to note is that these rules do not kick in as soon as the note trades below par, but when the note trades substabtially below par.

In English: The CPDO starts out at 15x leverage, and it stays at 15x leverage for as long as it needs to in order to make its coupon and principal repayments. In an ideal world it won't stay at 15x leverage for long, but if the market moves against it, it might stay there for years.

If the market does really badly, however, then the CPDO might be forced to deleverage anyway. In order for that to happen, the value of the credit instruments that the CPDO bought at issue would have to fall below 60 – essentially the entire index of investment-grade corporate bonds would have to be trading at distressed levels. Even if that happens, however, the CPDO doesn't delever all that much – a drop in net asset value to just 50 cents would bring leverage down only to 12.5x. Given that spreads would be incredibly wide at that point, 12.5x leverage might be sufficient to bring the structure back to par by maturity, especially if spreads come back down from the spike up.

Constant Proportion Debt Obligations (CPDOs): A Market Volatility Play, Not a Default Play