CLO – Collateralized Loan Obligation – A CLO is a specific form of CDO where the underlying collateral pool comprises loans.

Synthetic CDO – A Synthetic CDO is a specific form of CDO where the underlying collateral pool comprises CDS contracts.

Single Tranche CDO – A Single Tranche CDO is a specific form of Synthetic CDO where the full capital structure is not issued to investors. In this case, the "residual" exposure from the tranches that were not issued is "hedged" by the investment bank involved with the transaction.

CPDO – Constant Proportion Debt Obligation – As referenced in the December 2006 Investment Outlook by Bill Gross, the original form CPDO was offered as a high coupon (LIBOR + 200 basis points), highly rated (AAA) and highly levered (approximately 15x) 10-year security, comprising formulaic rolling of positions in 5-year iTraxx and CDX indices.

Rolling describes the selling of the current contract at maturity and reinvesting into the new "on-the-run" contract with a later maturity. The indices were required to be rolled every six months in order to maintain the AAA-rating of the note, which is achieved due to the "self-cleansing" nature of the index roll. In every roll, companies downgraded below Investment Grade are replaced by higher quality names in the new index. The high leverage generates carry in excess of the coupon. This enables the CPDO to "cash-in", i.e., repay the investor, and to de-lever before maturity, in the absence of losses due to defaults or excessive roll costs.

Following some detailed analysis and a lengthy discussion at PIMCO’s Investment Committee, it was calculated that credit spreads could only afford to tighten a further 3 to 4 basis points before the combination of coupon and rating could no longer be achieved.1 As it turned out, we were correct.

Since the original CPDO was launched in late 2006, the product has evolved even further to now allow for investment manager involvement in the bespoke construction of the underlying collateral pool and the trading of the pool over time. These managed structures can reduce the risk considerably to the extent that leverage can be adjusted over time, longs and shorts can be implemented in the portfolio, curve trades may be used and positions may be rolled opportunistically.

Credit CPPI – Credit Constant Proportion Portfolio Insurance – This type of structure generally consists of two parts:

A zero coupon note (i.e., a bond, without coupon, that pays no interest) that is sold at a discount from its face value and pays full face value at maturity, and;
A "risky asset" that consists of a levered instrument in a portfolio of CDS.
The leverage is increased if the portfolio performs well and reduced if it underperforms. The performance of the note derives from the risky portfolio and can be due to a combination of long credit exposure (also known as market beta, which mirrors the market performance) and so called "alpha", which is generated by actively managing a long/short portfolio.

Who Buys Structured Credit Products?
Now that we know the game, let’s look at the players. PIMCO has been managing structured credit products since 1996 across a broad variety of underlying asset classes, including: high yield and investment grade bonds, asset-backed securities, leveraged loans and synthetic CDOs comprising investment grade, crossover and emerging market collateral. As a result, we have an extensive database of the types of investors that have participated in our transactions to date.

From this database, we can offer the following insights:

Banks, insurance companies, asset managers and private investors have – in that order – tended to dominate the activity.
Investors have been domiciled in all regions of the world and specifically in the following countries: Australia, Austria, Belgium, Canada, China, Denmark, Finland, Germany, Hong Kong, Israel, Japan, Korea, Luxembourg, Malaysia, Netherlands, New Zealand, Philippines, Portugal, Saudi Arabia, Singapore, Switzerland, Taiwan, Thailand, United Kingdom and USA.
There has been global interest in the full capital structure, from AAA "Super Senior" tranches through to unrated equity investments, including principal protected versions.
Investment Opportunities
Credit derivatives and structured credit products are here to stay, so let us take a look at some of the technical intricacies of the sport. The impact of the flows from these products can have direct influences on the pricing of all credit markets. As a result, whether an investor is directly invested in these areas or not, it is still essential that they themselves – or more likely their fixed income manager – is ahead of the curve in terms of understanding the pitfalls and investment opportunities these advances have created. I outline a sample of these below:

Static Versus Managed Portfolios – Advancements in credit derivatives have facilitated the construction of so called static transactions (where the initial reference portfolio is not changed throughout the life of the transaction) and managed transactions (where the initial reference portfolio is actively managed over time by an independent investment manager). The technological development in the structured credit arena has increased the flexibility of the investment manager in terms of trading the underlying collateral pool.

Despite the numerous innovations in the credit markets, the credit cycle is NOT dead. As a result, we believe portfolios that are actively managed by third party investment managers with dedicated credit resources will be the outperformers over time. Also, considering that many such structures have final maturities of 10 years, the expectation of a benign default environment for the next two years should not provide too much comfort for the "buy-and-hold" investor.

Basis Trades – "Basis" is in this context a measure of the difference in spread (or interest rate differential to LIBOR) between a physical security and the derivative equivalent, for example of a bond and the equivalent CDS. Basis is not stable over time, so it can generate investment opportunities. In a negative basis trade, for example, a CDS trades at tighter spread levels than cash bonds. We can then buy the wider bond and buy the cheaper protection through CDS.