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Constant Proportion Debt Obligations (CPDOs) are best described as an investment strategy rather than an asset class. When they first appeared in August 2006, the asset on which CPDOs focused was long-only, unmanaged portfolios of investment-grade corporate debt, specifically the iTraxx and CDX credit default swap indices. Their strategy was to sell protection on the on-the-run indices, rolling into new indices every six months. But future CPDOs will invest in bespoke corporate portfolios, the subprime mortgage ABX index, and the commercial mortgage CMBX index. And several of the CPDO deals being talked around the market right now offer active management of bespoke portfolios, potentially with the flexibility to short credits.
There are three essential characteristics of the CPDO investment strategy that make a CPDO a CPDO. First, CPDOs cease investing when their profits are high enough to ensure return of principal and coupon to their investors. Rather than trying to maximize return, a CPDO stops taking on risk when profits are sufficient to ensure targeted internal rate of return. second, within limits, the further the CPDO is from achieving its profit goal, the more leverage it employs. Finally, they have high ratings that are derived from marketvalue risk analysis rather than credit analysis.
With respect to this last characteristic, a CPDO issues a single class of obligations, debt that is typically rated AAA for return of both principal and interest. In the case of rolling the CDX and iTraxx indices, the CPDO is exposed to the minute credit risk that a reference name will default within six months of being rated BBB- or higher. So rather than focusing on default and recovery, the proper CPDO analysis focuses on market risks such as 1) the costs associated with exiting the old off-the-run index, and 2) receipt of a low premium on the new on-the-run index.
Many market commentators missed this distinction when CPDOs first appeared. Citing structures that allowed maximum leverage levels of 15× and promised coupons as high as LIBOR plus 200 basis points, these commentators portrayed CPDOs as an example of irresponsible financial excess, a sort of debt Sodom and Gomorrah. But if that were the case, it would be easier to come up -with scenarios in which CPDO returns are less than promised.