CDOs demystified

Collateralised Debt Obligations (CDOs) have been part of the structured credit landscape for over a decade, though recent popularity has seen volumes rise considerably, with over $4 billion AUD of synthetic CDOs issued in the Australian and New Zealand market since 1999.

Sam Serisier, Senior Portfolio Manager Credit Markets at AMP Capital looks at the increasing popularity of CDOs and some of the key considerations for investors  thinking about adding them to their portfolio.

Key points

• CDOs tend to perform higher than similarly-rated bonds as the credit rating only reflects an average level of risk, rather than the dispersion of potential risky outcomes.
• Credit ratings are a key indicator for investors when assessing a CDO investment, though be wary that they don’t take into consideration all the risks.
• CDOs have performed well over the past few years, benefiting from an improved credit cycle. However, it’s now more important that investment mandates are flexible enough to perform through a complete credit cycle.

What are CDOs?

CDOs are securities backed by loans or bonds. These loans or bonds are split into different classes that pay investors from the cash flows they generate. By splitting the loans or bonds into classes, an investor’s claims against those assets are prioritised. They offer investors access to a diversified portfolio of credit risks in a single investment and provide enhanced returns corresponding to each investor’s appetite for risk.

These classes of loans or bonds are often referred to as ‘tranches’ and are categorised according to their degree of credit risk:

• senior (lower risk/lower yield),
• mezzanine (medium risk/medium yield), and
• junior/equity (higher risk/higher yield).

The most popular tranches are the mezzanine tranches. These tend to have higher returns than similarly-rated assets such as corporate bonds. If there are defaults or the CDO’s collateral otherwise underperforms, the higher risk tranches will be affected first. Senior and mezzanine tranches are generally rated reflecting both the credit quality of the underlying collateral and the level of protection given to a tranche.

Understanding CDO ratings and risks

A typical CDO sets the size of the equity tranche that protects investors in the mezzanine tranche from defaults in the underlying portfolio. For example, the equity tranche may protect the CDO from the first 5% of losses, meaning that if the underlying portfolio has 100 ‘names’ then 10 of these names may default  before the principal on the mezzanine tranche
is at risk.

At first mezzanine tranche investors are less affected by defaults than investors in the underlying portfolio though after a point, this is reversed. For example, if a mezzanine CDO tranche is protected from the first 5% of losses then this means that the principal is not at risk until losses from defaults in the underlying portfolio exceed 5%. The principal will, however, disappear if losses exceed some higher percentage (e.g. 10%). This means that while an investor in the underlying portfolio may only have lost 10% of their investment at this point, the CDO investor will have lost 100%, demonstrating that CDO investments can exhibit relatively high price volatility.

While there may appear to be some disparity between ratings and risk it’s important to remember there is little else an investor can rely on when assessing CDOs. The ratings don’t take into consideration all risks (e.g. unexpected loss) when determining the relative attractiveness of a CDO investment – rather they focus on expected loss or probability of default.

CDOs becoming increasingly complex

As credit markets have rallied and CDO spreads have closed in, new CDOs are increasingly looking for more complex ways to increase leverage without jeopardising ratings. Roughly a third of total CDO issuance since 2004 has been in a CDO-squared format (where the CDO itself is made up of a portfolio of CDOs) and it is doubtful that many of the investors in these products have understood the risks. In addition, it is becoming increasingly difficult for ratings agencies to keep up with the investment banks when analysing the risks of these products. Banks can deliver products that have ever-higher yields while apparently maintaining a certain credit quality (rating).

CDOs looking forward

According to Serisier, the view at AMP Capital is that CDOs are an exciting potential source of return but that investors need to be wary of the pitfalls. “We have built sophisticated models to analyse the risks of CDOs and consider ourselves to be structured credit
experts,” he said.

The complexity of the CDO market is making it more difficult for investors and advisers to distinguish what is a good investment and they are increasingly turning to the experts for advice. To meet these needs Serisier and his team have developed strong capabilities across both the more liquid swaps and tranche
markets and the less liquid buy and hold CDO market.

Look for expert advice

When looking to invest in CDOs, it’s important that prospective investors don’t rely solely on the agencies’ assessments. Rather, Serisier recommends investors look for active credit managers who have specific structured credit skills. CDOs are complex investments and it will not be initially obvious to your average investor whether a particular CDO represents value, unless they have the technology and capability to understand and analyse all the risks.

 

This article was produced by AMP Capital Investors Limited (ABN 59 001 777 591) (AFSL 232497). It is intended to provide general information, current at the time of writing, on investment-related topics. Although the information contained in the article was obtained from sources considered reliable, AMP Capital Investors does not guarantee it is accurate or complete in all respects. Therefore, readers should not rely upon this information when making investment decisions. Except where liability under any statute cannot be excluded, AMP Capital Investors, its employees and officers do not accept any liability (whether under contract, tort or otherwise) for any resulting loss or damage suffered by the reader or by any other person.

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