A Primer on Constant Proportion Debt Obligations

Abstract

A Constant Proportion Debt Obligation (CPDO) is best described as an investment strategy rather than an asset class. It is a debt-issuing special-purpose vehicle that employs the majority of cash received from note holders in a cash reserve account of liquid, high-quality assets and a small amount to pay initial deal expenses and then makes a leveraged synthetic investment in an index of debt securities. The example cited in this article involves selling protection on the iTraxx and CDX credit default swap indices, rolling from an off-the-run index into a new on-the run index every six months. The article describes the workings of CPDOs by explaining their initial flows, their revenue and expense items, and their three operating rules, which cover investment, cash in and cash out, and leverage. The authors explain the three risks CPDOs face: credit events on the portfolio they have sold protection on, a loss in exiting the old off-the-run index, and a low premium on the new on-the-run index. They further break down the cost of exiting the old index into an increase in the mid-market level of the index and an increase in the bid-ask spread of the index. The authors provide a brief discussion of interest rate risk, path dependency, and risk correlation in CPDOs. They conclude the article by showing the resiliency of one particular CPDO structure via scenario analysis. Their analysis demonstrates that, in keeping with its AAA ratings, it takes extreme conditions to cause a loss in this particular CPDO deal.