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Constant Proportion Debt Obligation (CPDO) Definition

What Is Trusty Proportion Debt Obligation (CPDO)?

Constant proportion debt obligations (CPDO) are incredibly complex debt safe keepings that promise investors the high yields of junk bonds with the low-default risk of investment grade relationships. CPDOs do this by rolling their exposure to the underlying credit indices they track, such as the Thomson Reuters Eikon practices (iTraxx) or credit default swaps index (CDX). As the given index sheds or adds bonds based on creditworthiness, a CPDO superintendent will limit default risk by updating their exposure, hence the term “constant proportion.” But the strategy remains constant proportion debt obligations highly exposed to spread volatility and at the risk of catastrophic loss.

Key Takeaways

  • Persistent proportion debt obligations (CPDO) are promise investors the high yields of junk bonds with the low-default danger of investment grade bonds.
  • CPDOs roll their exposure to the underlying credit indices they track.
  • CPDOs are authoritatively exposed to spread volatility.
  • Fundamentally, CPDOs represent the arbitrage of bond indices, and the strategy can lead to catastrophic extermination.

Understanding Constant Proportion Debt Obligation (CPDO)

Constant proportion debt obligations were invented in 2006 by the Dutch bank ABN AMRO. The bank, which hoped to create a high interest-bearing instrument pegged to bonds with the most exceptional debt ratings against lapse. During a period of historically low bond rates, such a strategy was appealing to the managers of pension funds who sought sharp returns but were not allowed to invest in risky junk bonds.

CPDOs are similar to synthetic collateralized debt covenants as they are a “basket” containing not actual bonds, but credit default swaps against bonds. These swaps synthetically haul gains from the bonds to the investor. But unlike synthetic collateralized debt obligations (CDOs), a CPDO is rolled in excess of every six months. The turnover comes from buying derivatives on the old bond index and selling derivatives on a new index. By continually purchasing and selling derivatives on the underlying index, the manager of the CPDO will be able to customize the amount of leverage it employs in an endeavour to make additional returns from index price spreads. It is an arbitrage of bond indices.

However, this master plan is at root a double-or-nothing, Martingale bet, which has been mathematically debunked. Martingale is an 18th century game of chance where a bettor duplicates their bet with every losing toss of a coin on the theory that an eventual winning coin toss force gain back all their losses plus the original bet. Among other limitations, the Martingale strategy only works if a bettor has far-reaching funds, which is never the case in the real world.

Limitations of CPDOs

The first CPDOs came under actual scrutiny after both Moody’s and Standard and Poor’s (S&P) rated them AAA investments. The agencies noted that the design of rolling with the underlying AAA indices would mitigate default risk. But critics focused on the risk of spread volatility immanent in the strategy. In typical times, this risk was arguably small since investment-grade bond spreads tend to come to mean. In that sense, the coin toss strategy could work. But bond spreads are historically stochastic, spirit they are difficult if impossible to predict and, in fact, remarkably few managers predicted the credit crisis of late 2008 that unwound numerous CPDOs.

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

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

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