What Is a🙈 Constant Proportion De🦋bt Obligation (CPDO)?

Constant proportion debt obligations (CPDO) are incredibly complex debt securities that promise investors the high yields of 澳洲幸运5开奖号码历史查询:junk bonds with the low-default risk of investment-grade bonds. CPDOs do this by rolling their exposure to the underlying credit indices they track, such as the Thomson Reuters Eikon code (iTraxx) or the 澳洲幸运5开奖号码历史查询:credit default swap index (CDX).

As the given index sheds or adds bondཧs based on creditworthiness, a CPDO manager will lim♋it default risk by updating their exposure, hence the term “constant proportion.” But the strategy leaves constant proportion debt obligations highly exposed to spread volatility and at the risk of catastrophic loss.

Understanding a Constant Proportion Debt Obli🍨gation (CPDO)

Constant proportion debt obligations were invented in 2006 by the Dutch bank ABN AMRO. The bank sought to create a high interest-bearing instrument pegged to bonds with the most exceptional debt ratings against default. During a period of historically low bond rates, such a strategy was appealing to the managers of 澳洲幸运5开奖号码历史查询:pension funds who sought higher returns but were not allowed to inves✨t in r🤡isky junk bonds.

CPDOs are similar to 澳洲幸运5开奖号码历史查询:synthetic colཧlateralized debt obligations as they are a “basket” containing not actual bonds, but 澳洲幸运5开奖号码历史查询:credit default swaps against bonds. These swaps synthetically transfer gains from the bonds to the investor. But unlike synthetic collateralized debt obligations (CDOs), a CPDO is rolled over every six months. The turnover comes from buying 澳洲幸运5开奖号码历史查询:derivatives on the old bond index and selling derivatives on a new index. By continually buying and selling derivatives⛄ on the underlying index, the manager of the CPDO will be abꦕle to customize the amount of leverage it employs in an attempt to make additional returns from index price spreads. It is an arbitrage of bond indices.

However, this strategy is at root a double-or-nothing, 澳洲幸运5开奖号码历史查询:Martingale bet, which has been mathematically debunked. Martingale is an 18th century game🍌 of chance where a bettor doubles their bet with every losing toss of a coin on the theory that an eventual winning coin toss will gain back all their losses plus the original bet. Among othe𓆉r 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 O✃bligations (CPDOs)

The first CPDOs came under immediate scrutiny after both Moody’s and Standard and Poor's (S&P) rated them AAA investments. The agencies noted that the strategy of rolling with the underlying AAA indices ඣwould mitigate default risk. B𓂃ut critics focused on the risk of spread volatility inherent in the strategy.

In typical times, this risk was arguably small since investment-grade bond spreads tend to revert to mean. In that sense, the coin toss strategy could work. But 澳洲幸运5开奖号码历史查询:bond spreads are historically 澳洲幸运5开奖号码历史查询:stochastic, meaning they are difficult if i💙mpossible to predict and, in fact, ▨remarkably few managers predicted the credit crisis of late 2008 that unwound many CPDOs.

The first CPDO default came in November 2007 to a fund administered by UBS. It was the canary in the coal mine, as bond spreads began spiking in advance of the 2008 market crash. As more funds began to unwind, the rating agencies Moody’s and S&P fell under increased scrutiny for granting AAA ratings to CPDOs. As their credibility suffered, Moody’s discovered an internal software glitch that they said was at least partly responsible for the positive rating, although that did nothing to explain S&P’s rating.

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