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Should Your Next Deal be Cash or Synthetic?. CDOs in the Heartland March 20, 2003. Marion Silverman. Types of Synthetic CDOs. Static Investment Grade Synthetics Eg. SALS, EPOCH. n th to Default Baskets Eg. (private). High Yield Arbitrage CLOs Eg. SERVES, ELFS. Synthetic Structures.

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should your next deal be cash or synthetic

Should Your Next Deal be Cash or Synthetic?

CDOs in the Heartland

March 20, 2003

Marion Silverman

types of synthetic cdos
Types of Synthetic CDOs

Static InvestmentGrade SyntheticsEg. SALS, EPOCH

nth to DefaultBasketsEg. (private)

High Yield Arbitrage CLOs




Synthetic Bond

Fund Ratings

Eg. HYDI Credit Linked Trust

Single Name CreditLinked NotesEg. TIERS Trust

Managed Synthetics

Eg. Shoreline

synthetic hy arbitrage cdos
Synthetic HY Arbitrage CDOs
  • CDO arbitrage programs are sponsored by higher rated financial institutions for the benefit of CDO managers.
  • Allow managers and capital market investors to replicate economics of cash arbitrage CDOs via credit derivatives.
synthetic hy arbitrage cdos4
Synthetic HY Arbitrage CDOs
  • To date, in the U.S., the only asset class has been domestic senior secured bank loans, reflecting the predictability of recoveries and a growing secondary market.
  • Going forward, expect asset classes to broaden, including European leveraged loans, middle market loans, and ABS.
features of synthetic hy arbitrage cdos
Features of Synthetic HY Arbitrage CDOs
  • Credit Default Swap or Total Return Swap
  • Fully Funded
  • Cashflow or Hybrid (Market Value) Structures
  • Counterparty Exposure
  • Collateralized
synthetic hy arbitrage cdo total return swap

$300 MM

Loan Portfolio

$47.5 MM

‘BBB’ Notes

$2.5 MM



Excess Reserves

Synthetic HY Arbitrage CDO (Total Return Swap)

$50 MM


Collateral Account



Cash Flow

Net Issuance





Bank of


(Total Return

Swap Provider)


Portfolio Cash Flow, Net of Swap Rate

(L+ Spread Paid to Bank of America)




Investment Manager

Source: Bank of America Securities LLC. Diagram of a SERVES transaction.

motivations for hy arbitrage synthetic vehicles
Motivations for HY Arbitrage Synthetic Vehicles


  • Structuring/Fee Income
  • Distribution Outlet for Originations
  • Improved Flow for Secondary Trading
  • Smaller Unrated Equity Component
  • Favorable Capital Treatment
motivations for hy arbitrage synthetic vehicles8

“Captive” Assets Under Management

Administrative Efficiency

Attractive Cost of Funding/Arbitrage

Structural Advantages

Ability to Realize Leveraged Returns

Motivations for HY Arbitrage Synthetic Vehicles
motivations for hy arbitrage synthetic vehicles9

Attractive Cost of Capital/Arbitrage

Favorable Capital Treatment

Stable Rated Coupon with Upside Opportunity

Managers with Established Track Records

Motivations for HY Arbitrage Synthetic Vehicles
rating considerations
Rating Considerations

Ratings for synthetic arbitrage CDOs build off established CDO criteria, including default scenarios and recoveries. Other unique considerations include:

  • Collateral Requirements
    • liquidity
    • credit quality
    • coupon
  • Portfolio Yield
    • structural role of excess spread
    • assume yield compression
  • Triggers
    • mark-to-market thresholds
    • other
  • Counterparty Exposure
    • vis-à-vis CDO rating
    • collateralization
comparison with cash cdo
Comparison with Cash CDO
  • Coupon
  • Subordination
  • Ramp Up
  • Structural Tests
  • Flexibility
synthetic hy arbitrage cdo bbb rating
Synthetic HY Arbitrage CDO (BBB Rating)

Reference Portfolio Yield L + 265*

Less: Senior Financing / Total Return Swap <L + 70>

Less Current Management Fee/Admin Fees <30>

Equals = Available Excess Spread 165

Available Excess Spread provides levered cash flow to cover credit losses as well as rated note coupon and equity coupon

*Fitch stress assumption.

priority of payments
Priority of Payments

* Assumes LIBOR at 3%


(Both Cash and Synthetic)

  • Upfront selection key to success
  • Low individual exposures
  • High credit quality better than high spread
  • Slow and steady
  • Managers can make a difference