Managed deal attracts interest

Lehman Brothers and Prudential M&G have completed what is thought to be the first managed synthetic CDO equity tranche to carry a credit rating. Last month Lehman traded ?100 million of the Bison Notes issue in a private deal rated A3 by Moody's. The seven-year notes represent a 0% to 3.65% position in a reference portfolio with an average rating of single A, which is equivalent to ?1.5 billion in risk-weighted terms.

Officials at Lehman Brothers say the single-tranche deal uses a structure similar to a static deal completed six months ago known as Orion. However, on the Bison deal, Prudential M&G actively manages the reference portfolio. "The deal was oversubscribed, and 100% of the investors who met with Prudential M&G and Lehman Brothers invested in the transaction," says Sridhar Bearelly, global head of CDO syndication at Lehman Brothers in London. "This strong demand reflects Prudential M&G's reputation as a top-tier manager as well as the innovative structure of the deal."

The notes are able to achieve a single A rating despite being exposed to an equity position in the portfolio because they pay a low guaranteed coupon of 70 basis points. The remaining income from the portfolio of 135 investment grade names is paid into a reserve account which is used to absorb credit events. The notes are overcollateralised at the outset to cope with any early defaults in the portfolio.

The trade is part of a wave of innovation in the credit derivatives market as dealers look for new ways to distribute structured credit equity. "Equity has looked cheap on a relative value basis since May 2005," points out Lisa Watkinson, head of structured credit business development at Lehman Brothers in New York. "However, real money investors have not been able to take advantage of that cheapness because they can't generally buy unrated equity."

Other structures designed to repackage first-loss credit tranches into new formats include the zero-coupon structures which have been popular for the past six months and combination notes. Some CPPI transactions have also been linked to equity tranches. However, this is thought to be the first time that a deal based solely on an equity tranche has gained a credit rating for return of both principal and interest.

"One of the main reasons banks, insurance companies and fund managers have not historically invested in CDO equity is that it is not rated," says Bearelly. "This structure allows these investors to capture value all the way down to equity without changing their guidelines."

The deal was sold to investors in several European countries, including banks, insurers and fund managers, but not hedge funds.

Dagmar Kent Kershaw, head of CDOs at Prudential M&G in London, agrees that this is an innovative structure with a lot of future potential, but says it is particularly important to have a manager in a first-loss tranche. "As with all the CDOs we manage [the firm now has nine cashflow and seven synthetic CDOs under management] our portfolio management strategy is based on fundamental credit analysis," she says. "We will take a reasonably cautious stance, trading around 20-30% of the portfolio a year based on changes in relative value."

Michael Peterson