What Is Constant Proportion Debt Obligation?

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

Understanding Constant Proportion Debt Obligation (CPDO)

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

CPDOs are similar to synthetic collateralized debt obligations as they are a “basket” containing not actual bonds, but credit default swaps against bonds. These swaps synthetically transfer gains from the bonds to the investor. But unlike synthetic collateralized debt obligations (CDOs), a constant proportion debt obligation is rolled over every six months. The turnover comes from buying derivatives on the old bond index, and selling derivatives on a new index. By continually buying 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 attempt to make additional returns from index price spreads. It is an arbitrage of bond indices.

However, this strategy 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 doubles their bet with every losing toss of a coin on the theory that an eventual winning coin toss will gain back all his losses plus his original bet. Among other limitations, the Martingale strategy only works if a bettor has unlimited funds, which is never the case in the real world.

Limitations of CPDOs

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

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

In hindsight, both agencies had assigned an effective zero risk probability of the 2008 event, and they also assigned a very small probability to the more mundane spread rise that occurred in late 2007—which in fact was no different from what had happened in 2001-03.

The debacle of 2007-08 made CPDOs the poster child for overly-complex financial instruments—and head-in-the-sand optimism that they can defy gravity.