Definition of constant proportion debt obligation (CPDO)

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What is a constant proportion debt obligation (CPDO)?

Constant Proportion Bonds (CPDOs) Are Incredibly Complex debt securities that promise investors the high returns of junk bonds with the low risk of default of higher quality bonds. To do this, CPDOs roll their exposure to the underlying credit indices they track, such as the Thomson Reuters Eikon (iTraxx) code or the credit default swap index (CDX).

As the given index loses or adds bonds based on creditworthiness, a CPDO manager will limit the risk of default by updating their exposure, hence the term “constant proportion”. But the strategy leaves constant-ratio debt securities heavily exposed to spread volatility and the risk of catastrophic losses.

Key points to remember

  • Constant proportion bonds (CPDOs) promise investors the high returns of junk bonds with the low risk of default of investment grade bonds.
  • CPDOs roll their exposure to the underlying credit indices they track.
  • CPDOs are highly exposed to spread volatility.
  • Basically, CPDOs represent bond index arbitrage, and the strategy can result in catastrophic losses.
  • CPDOs began to default at the onset of the Great Recession, and rating agencies, such as S&P and Moody’s, came under scrutiny for rating CPDOs highly.

Understanding a Constant Proportion Debt Obligation (CPDO)

Constant proportion debt securities were invented in 2006 by the Dutch bank ABN AMRO. The bank was looking to create a high interest rate instrument ankle to bonds with the most exceptional debt ratings against default. During a period of historically low bond rates, such a strategy appealed to investment managers. pension funds who were looking for higher yields but were not allowed to invest in risky bonds.

CPDOs are similar to synthetic secured debt securities since it is a “basket” containing not real obligations, but credit default swaps against bonds. These swaps synthetically transfer the gains of the bonds to the investor. But unlike synthetic collateralized debt obligations (CDOs), a CPDO rolls over every six months. The turnover comes from the purchase derivatives on the old bond index and sell derivatives on a new index. By continually buying and selling derivatives on the underlying index, the CPDO manager will be able to customize the amount of leverage they employ in an attempt to generate additional returns from price differentials. of the index. This is an arbitrage of bond indices.

However, this strategy is basically a double or nothing, martingale bet, which has been mathematically debunked. Martingale is an 18th century game of chance where a bettor doubles their stake with each losing coin toss on the theory that an eventual winning coin toss will recoup all of their losses plus the original bet. Among other limitations, the Martingale strategy only works if a bettor has unlimited funds, which is never the case in the real world.

Limitations of constant proportion debt obligations (CPDO)

Early CPDOs came under immediate scrutiny after Moody’s and Standard and Poor’s (S&P) rated them AAA investments. The agencies noted that the rolling strategy with the underlying AAA indices would mitigate default risk. But criticism has focused on the risk of spread volatility inherent in the strategy.

In normal times, this risk was probably low since spreads on higher quality bonds tend to revert to the mean. In this sense, the coin toss strategy could work. But bond spreads are historically stochasticmeaning they are difficult if not impossible to predict and, in fact, remarkably few managers predicted the late 2008 credit crisis that unwound many CPDOs.

The CPDO’s first default occurred in November 2007 for a fund administered by UBS. It was the canary in the coal mine, as bond spreads began to soar ahead of the stock market crash of 2008. As more funds began to unwind, rating agencies Moody’s and S&P made the under increased scrutiny for awarding AAA ratings to CPDOs. As their credibility suffered, Moody’s uncovered an internal software glitch they believe was at least partly responsible for the positive rating, though it did nothing to explain S&P’s rating.

In retrospect, both agencies had assigned an effective zero risk probability to the 2008 event, and they also assigned a very low probability to the more mundane increase in spread that occurred in late 2007. The debacle from 2007 to 2008 made CPDOs the poster child for overly complex financial instruments and gravity-defying head-in-the-sand optimism.

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