Getting proactive on CDOs

Many investors believe that fixed interest investments represent a safe haven in volatile markets, but Deutsche AssetManagement’s Bill Bovingdon cautions against becoming too sanguine in circumstances where a tightening of conditions seems inevitable in 2007.

Bovingdon bases his analysis on an examination of credit cycles and has concluded that the current period represents a cycle like no other, given the high level of exposure to leverage products.

“The striking difference between this and past cycles is the growth of credit derivatives and credit products offering leverage,” he said.

Bovingdon points to the growth in the collateral debt obligations market between 1996 and in particular the rapid growth that occurred between 2003 and 2005 as proof of this, along with the growth in the global credit derivatives market.

He said this means there is a lot more leverage being carried by investors who could best be regarded as inexperienced.

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Collateralised debt obligations (CDOs) are securities that are exposed to the credit risk of a number of corporate borrowers.

In the simplest form of a CDO, this credit risk exposure is generated in the same way as for any asset-backed security (ABS): the CDO is backed by outright holdings of corporate debt, such as corporate bonds and corporate loans. Increasingly, however, the exposure to corporate credit risk is synthesised through the use of credit derivatives.

Bovingdon said that while there were no storm clouds obviously gathering on the horizon, investors would be well-advised in reviewing their fixed interest allocations — what they are holding and what they would like to hold.

“They should be doing their preparation right now because it is never too early to consider a change in settings, particularly when conditions remain benign in terms of low volatility, low risk premiums and lower interest rates,” he said.

Bovingdon is not alone in suggesting that investors should be reviewing their exposures, with the Reserve Bank last year pointing to the growth in CDOs and the underlying economic risks.

It said that, in general, the growth in CDO issuance in Australia is supportive of financial stability to the extent that it had allowed credit risk to be spread across a range of investors, rather than concentrated on the balance sheets of a small number of domestic financial institutions.

“With total outstandings of $5.7 billion, the Australian CDO market is currently not large enough to be of systemic importance to the financial sector. However, the available evidence suggests that CDOs constitute a reasonable proportion of some investors’ financial assets, and the increased issuance of CDOs does raise a number of issues,” the Reserve Bank analysis said.

It said that most notable among these issues was that some investors, in seeking higher returns in a low-interest rate environment, might be underestimating the risks of these securities.

“One issue for Australian investors, and the financial system more generally, is that the proportion of Australian debt in the reference pools of domestically issued CDOs has fallen to quite low levels over the past few years. This has meant the major drivers of the risk characteristics of CDOs held by domestic investors may not be credit events related to the Australian financial system,” the analysis said.

“While it is necessary for non-resident borrowers to be included in domestically issued CDOs to ensure that the reference pools are well diversified, to the extent that overseas CDOs do not incorporate an offsetting amount of domestic corporate debt, the Australian financial system has been a net recipient of global credit risk,” it said.

The Reserve Bank analysis said that another issue for Australia was that retail investors had tended to buy lower-rated CDO tranches than had their institutional peers, potentially leaving them more exposed to losses if the global economy were to suffer a period of economic stress.

For his part, Bovingdon said the key for investors was not to assume that just because they had a fixed interest allocation it meant they were appropriately geared in the event of a tightening of policy by the central banks.

He said there was a need for investors to understand the consequences of a downswing in the credit cycle and to prepare accordingly.