CSO momentum builds as focus turns to fundamentals

Dan Alderson

Deputy editor

Collateralised synthetic obligations (CSOs) have proved to be a bright part of the credit market in 2022. And participants are daring to dream the coming year will be one of the asset’s busiest.

Volatility has wreaked havoc across credit since Russia’s invasion of Ukraine in late February, which ramped up concerns about inflation and dealt a massive blow to many companies’ ability to finance in the primary market. But the same dynamics have stoked investor interest in obtaining synthetic exposure, with bespoke tranches a clear beneficiary.

“There has been very positive momentum on the asset class and 2022 has been on a par with the pre-covid volume of 2019,” says Guillaume Mear, head of structured credit trading at BNP Paribas. “We see a good balance in demand across the capital structure, with investors looking to buy equity, mezzanine and senior tranche positions — and no single tranche is really leading the others or hampering our ability to execute new business.”

Mear: ‘The credit market’s focus is shifting from liquidity risk to fundamental risk’

CSO volume in 2019 amounted to around $65 billion, but appetite for risk trailed off that year after a strong first half due to the absolute tightness of credit spreads.

The key difference this time around is the direction of travel. From March 2020, some prominent CSO participants came unstuck amid extreme volatility. Most activity that year was in the secondary market, but now primary trade has returned.

Focus in 2022 was on the front end of the duration curve, with one-year and two-year CSO exposure proving popular. This reflected a view on likely default rates versus the absolute wideness of spreads.

But new participants (including CLO investors), as well as dealer support for single name liquidity outside standard five-year duration, helped. The market also produced more traditional three-year CSO business and even some five-year portfolios.

“The credit market’s focus is shifting from liquidity risk to fundamental risk, with default rates expected to pick up in 2023,” says Mear. “Bespoke tranches offer credit investors the flexibility to narrow down their exposure to a specific set of credits.

“Maturity also matters. High yield primary volumes are down 70-80% year-on-year and liquidity buffers are running low for leveraged issuers. One may only get comfortable underwriting credit risk up to one or two years, and bespokes offer them the flexibility to trade new risk on short-dated tenors.”

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Global credit funds & CLO's

January 2023 | Issue 251

Published in London & New York.