Will bespoke single tranches make a comeback, asks Anu Munshi, partner at B&B Structured Finance

Last month, JPMorgan and Morgan Stanley scrapped plans to launch a synthetic CDO. Apparently there wasn't enough interest from investors in the senior most tranche.

But if investors were interested in the mezzanine and junior tranches, JPMorgan or Morgan Stanley could create bespoke single tranches for them. Activity in such tranches ran into hundreds of billions of dollars pre-credit crisis. There are reports of banks currently structuring such bespoke tranches for their clients, but it is tough to tell the volumes as these are one-off, customised deals.

Currently certain factors would seem to encourage the resurgence of bespoke single tranches. From an arranging bank's perspective, not having to line up investors for every part of the capital structure for a synthetic CDO - instead creating single tranches for investors based on their investment requirements - could be a more efficient way to structure deals.

However, creating such bespoke tranches involves taking on more risk for the bank than arranging a fully distributed synthetic CDO. The risks involve dynamically managing the spread, default, correlation and recovery risks of the portfolio underlying the single tranche as the bank has created a single tranche out of a portfolio of credit risk.

Banks today may not be as willing to take on such risks as they were before the credit crisis. Some banks have exited the single tranche market completely; so there is an opportunity for the banks that are willing to revive this business. However, regulatory capital requirements have reduced the profitability of these products for banks, so banks will have to weigh the costs and benefits of the business overall and potentially of each deal, before determining whether this is a worthwhile exercise.

From an investor's perspective, the overall low yield environment may spur some to look at more structured products for a better yield within a rating category. Investment grade rated single tranches could be an attractive alternative to high yield bonds, which can be volatile and have taken a hit with the recent increase in yields.

But even if investors are interested in buying a certain tranche - say a single-A rated tranche - of a fully distributed synthetic CDO, they may not be comfortable with buying a single-A rated bespoke single tranche with the same underlying portfolio as the synthetic CDO. This is because the bespoke tranche has been tailored for the investor, so there are no other investors in the deal. The resulting lack of liquidity - particularly at a time when liquidity is at a premium - may keep investors at bay.

Further, the regulatory push to increase transparency and encourage central clearing in derivatives could work against single tranches as their structured and tailored nature precludes them from being centrally cleared. Over time, as more derivatives are centrally cleared, bilateral and tailored derivatives are likely to become less liquid - further reducing the liquidity of bespoke tranches.

Even if some investors are dipping their toes into the single-tranche waters again, we are still far from seeing a resurgence in volumes à la 2005-2007. The fact is that CDOs and single tranches depend on ratings. And one of the painful lessons from the credit crisis was the market's over-reliance on rating agencies.

Part of the reason there isn't enough interest in the senior most tranches of synthetic CDOs is that many investors who bought these in the past suffered downgrades and were forced into distressed sales or restructuring their tranches at less favourable terms. Much confidence needs to be restored in this area before investors start piling back in.

Will bespoke single tranches make a comeback? The trickle has begun, but it may be a while before the market is flooded with them again.