The hazards of CDOs became painfully apparent in April, when ratings agency Standard & Poor’s jolted the credit markets by downgrading the debt of General Motors and Ford Motor Co. to junk status. Beyond surprising many investors and analysts, this event mauled hedge funds that had taken positions in CDOs that contained GM or Ford debt. According to press reports at the time, several hedge funds—none were actually named—had arbitrage positions that made money if the credit quality of all the debt in specific CDOs moved in tandem, but could lose money dramatically if the credit quality of just one or two companies took a pounding. Ford and GM are widely held in CDO portfolios, and when they suffered downgrades, the hedge funds exposed to these transactions took a hit.

In the current very tight credit environment, these risky investments are paying out anywhere from 12 to 17 percent.

These losses by the ostensible smart-money people led some to question whether private investors should be venturing into this space at all. Marc Freed, managing director of New York–based Lyster Watson, a fund-of-funds manager, has a good understanding of the CDO markets from his experience in the asset-backed securities business in the late 1990s. He calls the CDO market a great business, but only for institutional investors who truly understand the products. “I think it is an inappropriate area for high-net-worth individuals because they really won’t have any idea what they are buying, and they’ll have no capacity to analyze it,” he says. “As a rule, we will not invest in hedge funds that are doing much in the structured credit area, even if they are well qualified, because we perceive it to be illiquid in difficult markets.” Michael Mullaney, vice president and investment officer at Boston-based Fiduciary Trust, agrees: “These are definitely riskier and more complex than other investments.”

TOP VIEW Collateralized debt obligations (CDOs) pool individual credits and repackage them in the form of securities that are then sold to investors. While the potential returns of CDOs are impressive—in the current environment the most risky CDO tranches are delivering between 12 and 17 percent—the high degree of risk that investors must take on and the sheer complexity of the instruments themselves lead some experts to warn individual investors to stay away.

But despite their complexity, CDOs continue to attract private investors. “Very high-net-worth investors have been active in this market for a number of years,” says Drew Dickey, Springfield, Mass.-based managing director and head of the structured credit unit at Babson Capital Management, which specializes in constructing and arranging CDOs. He adds that interest from affluent investors has tracked the explosion in CDO volumes in recent years. “Over the period from 1997 to 2002, pretty much all the investment banks came around to concluding that it was a suitable product to sell to the high-net-worth.”

The potential for high returns with CDOs is the draw—specifically, the performance offered by equity tranches, the below-investment-grade slices of CDOs. (The term “equity” is due to their bottommost position in the CDO capital structure.) Two or three years ago, investors in these vehicles pulled in returns in the range of 15 to 20 percent. In the current environment, with credit spreads extremely tight, Dickey estimates these investments are returning anywhere from 12 to 17 percent.

Tranche Warfare
The term “CDO” has evolved since the 1990s, and it now serves as the moniker for a range of debt securitizations, including collateralized loan obligations, collateralized mortgage obligations and collateralized bond obligations. The collateral in a CDO is an important factor in its risk profile. Mortgages, for example, are difficult to model (they have the homeowners’ prepayment options embedded in them), and the behavior of collateralized mortgage obligations is therefore fiendishly difficult to predict. The fact that the CDO arranger is usually in charge of assembling the collateral is another source of risk. Some banks and asset managers have been accused of dumping their own rotten credits—or ones they know are about to turn sour—into CDOs before selling them to unsuspecting investors.

“The risks are more complicated because you have tranching,” adds Mark Adelson, a CDO analyst with Nomura Group in New York. CDOs are carved up into different tranches (from the French term for “slice”), each of which has a different risk profile, akin to the seniority and liquidation preference in a corporate capital structure. Indeed, CDOs borrow the terms—equity, mezzanine, senior—used to refer to the different levels of a corporate capital structure. (See "A Guide to CDO Structures”)

However, once you start to incur a loss on a CDO position, it can become very severe very quickly, Adelson says. Therefore, investors should not assume that a CDO tranche rated, say, BB, carries the same risk as a company with the same credit rating. The two behave very differently under stress. “It’s more of an all-or-nothing bet.” (Click image to enlarge)

The challenge lies in determining just how risky this bet actually is. In the case of a CDO exposed to corporate collateral, for example, the risk depends on how closely the credit qualities of the underlying companies move in line with each other—in other words, how correlated they are. Measuring something as esoteric as corporate credit correlation is extremely difficult and somewhat subjective. “There are people who spend a great deal of time trying to assess those correlations, and some do it well and some do it less well,” says Dean Smith, New York–based portfolio manager with investment company Highland Financial Holdings.

As CDO markets have matured, so too has the complexity of the products on offer. For the last several years, the biggest growth area has been in synthetic CDOs, which are backed by a pool of credit derivative exposures to companies, rather than by actual corporate bonds. The most sophisticated financial institutions have developed the ability to create just a single, tailored tranche of such a synthetic instrument in response to an investor’s specific needs, obviating the need to build an entire CDO capital structure and finding investors for all the other parts. These single-tranche synthetic CDOs were among the instruments that hurt the hedge funds exposed to GM and Ford.

While banks have been churning out these instruments on a regular basis for private investors for the past two years or so, some experts say caution is warranted. “If you are not experienced and resourced to participate as a professional, then you will regret it,” Dickey warns.

The exposure of most private investors to the synthetic CDO market will most likely be indirect, via investment in hedge funds. But as events earlier this year showed, the market is so unpredictable that even these supposedly savvy operators can take a hammering in it. Ultimately, those private investors considering an investment in CDOs, and especially in single-tranche synthetic CDOs, must seek out the most experienced advisors possible, and should bear in mind that the sheer complexity of many of these instruments means that even top-flight advisors may not fully understand their risks.

John Ferry is an Edinburgh, UK-based journalist who specializes in writing about financial markets and investments. 

Additional Information
 A Guide to CDO Structures