Some structured products are invested in CDOs (collateralised debt obligations). These are described as their "underlying assets".
These underlying assets are NOT the same as the "reference entities" which are used to determine the additional return based on certain complicated formulas involving their share prices.
As the reference entities are large, familiar companies, many investors MISUNDERSTOOD that their money are invested in these entities (which is NOT the case).
CDOs are invested in bonds and mortgages of various quality (including subprime mortgages that are now seeing high default rates in USA). The manager re-packages the assets into various tranches of the CDOs, rated from AAA (least risky) to the equity tranche (most risky).
The rating of CDOs are NOT the same as the rating of corporate bonds. CDOs earn a higher return (up to 2% p.a. more) than corporate bonds, due to the higher risk.
If you buy a structured product that is invested in the CDOs, you may not get the full extent of the higher return (for the higher risk), due to the expenses of the structured product.
Two large funds managed by Bear Stearns have made significant investment in CDOs which were rated AA or AAA. They have recently marked down the value of these highly rated CDOs significantly. The investor in their funds have lost most or all of their money. (This is a worst case scenario).
Lessons:
Avoid investing in CDOs, either directly or through structured products, unless you are familiar with this type of product, and you get a return that commensurate with the risk.
The CDOs are revealed after the launch so you can assess their aggregate risk or individual risk. Usually, it is at least a double As rating.
ReplyDeleteThere must at least 10-15 defaults from the assets before it constitutes a credit event.
Here's some advice from Guide to Investment Strategy (Peter Stanyer, The Economist, 2006) page 129-130.
ReplyDelete(You can search and view parts of the book at Amazon here if you register.)
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Who should invest in CDOs?
No one needs to invest in CDOs, and no one should invest in any instrument unless they are sure that they, or a trusted adviser, understand and can monitor the risk and potential rewards involved. This means that they need to understand the complex issues involved in pricing CDOs and, in particular, different tranches of a CDO.
...Investors who have used CDO tranches as a means of getting around a prohibition on investing in sub-investment grade assets need to assess the likelihood of such a downgrade, and all investors need to be satisfied that these disappointment risks are sufficiently reflected in the investment return that the CDO tranche offers.
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Message: Make sure you or your trusted adviser know the risk, the return, and if the complicated product is priced fairly.
Sub investment grade assets such as sub prime loans were securitised as CDOs to give higher returns. These
ReplyDeletekinds of CDOs investors must know and understand before putting their money.Key to the understanding is the adviser who must disclose whatever is necessary, especially the risk, for investors to make informed decision.