Fear Cycle Ensnares Structured Products

The IG9 index reflects the cost of insuring against default by 125 U.S. and Canadian investment-grade companies. It widens when investors buy protection in anticipation of further troubles in corporate credit. Structured products also used the index, primarily selling protection, as part of elaborate money-making strategies. The widening index is putting extraordinary pressure on complex products such as constant proportion debt obligations and collateralized debt obligations, and is threatening to trigger the unwinding of investment positions. CPDOs emerged in late 2006. In world where yield was king, CPDOs offered not just generous returns but top-notch ratings. To generate those returns, they used substantial leverage -- about 15 times the principal. CPDOs sell credit protection against a possible default in the underlying bonds of the CDX. In exchange for the index protection, CPDOs receive premiums, a portion of which are used to pay off their investors. "What were perfectly viable financing strategies are being pulled apart as lenders steadily increase margin calls in the midst of declining collateral values," said Fran Mustaro, managing director at J. & W. Seligman & Co in New York. The next unwind trigger for CPDOs is around 2.00 percentage points on the benchmark CDX, according to analysts at Banc of America Securities, not far from Friday's close at 1.77 percentage points. This means the annual cost of five years of insurance against a default on $10 million of bonds in the I9 index is $177,000, a rise of $44,000 since its close on Feb. 26, according to Barclays Capital.