Over the past several years, Canadian participation in the credit derivatives market, including collateralized debt obligation (CDO) structures, has experienced significant expansion, says Dominion Bond Rating Service.

In a newly published study, the rating agency says that, while some observers have been leery of this development, it believes the trend should be welcomed.

DBRS reports that reservations about this trend appears to fixate on the premise that CDOs are inherently risky and are not as suitable a structured product for conduits, compared to traditional securitizations. A conduit is a trust that buys financial assets by issuing commercial paper and long and medium term debt.

Support for the cautious view toward conduit participation in the credit derivatives market is the past performance of CDOs, particularly performance through the difficult credit markets of 2001 and 2002, it says. “This reservation, however, ignores the fact that the description of something as a CDO is only the beginning of an analysis,” says DBRS managing director Mark Adams. “CDOs can have very different behavioural and risk characteristics depending on the myriad factors specific to each transaction.”

In realizing this, and in the development of the Canadian conduit market, Canadian conduits have evolved to select sophisticated, conservative products that are as suitable as other structured products for conduit placement, it says.

DBRS adds that it expects to see conduit participation in the CDO space continue to expand. “The thrust of this development will be the purchase of low-risk structured credit product by the conduits. The conduit market is well-suited to the purchase of large, remote credit risk exposures,” it says.

The firm says it would like to see conduit-purchased CDOs perform in a manner similar to Canadian asset-backed securities with respect to downgrade and loss behaviour. DBRS believes this performance is attainable since the CDO market does offer significant opportunities for exposures to remote risks. “With similar performance parameters, there should be no objection to the conduit CDO market growing in size, particularly since securitization issuance is unlikely to grow,” it says.

“In conjunction with the growth in CDOs and structured credit, investors will also likely see a great deal more disclosure from conduits participating in the CDO marketplace,” it adds. “DBRS has helped initiate and encourage greater disclosure, particularly with the practice of specifically designating arbitrage vehicles. Having said this, disclosure will be improving, regardless of whether exposures are in multi-seller conduits or in specialized arbitrage conduits. Increased disclosure will help investors become more comfortable and it should also aid in helping to educate investors in this complex, fast-growing marketplace.”