The number of long/short CDO structures, or strategies that generate alpha in a deteriorating credit environment, is on the rise. There are very few managed CDOs currently in the market that do not try to include some sort of short strategy. Incorporating efficient long/short techniques into CDOs has become one of the most challenging goals because extracting every last basis point of extra yield is no longer generally perceived to be the best strategy in credit.
It is easy to understand why the consensus over going long corporate credit – which was generally the correct credit strategy over the past four years – has evaporated. The momentum behind a four/five-year bull market is facing a serious check in the form of sub-prime woes and slowing US economic growth.
In the CDO world, an efficient long/short structure is something of a holy grail. It is one thing to make money from taking a leveraged exposure to a CDO portfolio, but creating value when spreads also widen is clearly an attractive proposition.
Short buckets
In recent years the rating agencies have accepted the incorporation of short strategies in CDOs but tend to penalize short buckets in CDO structures – that is, a ring-fenced portion of the deal used by the manager to express a negative view on individual credits.
