Janine Starks, Representative of www.structuredretailproducts.com and principal of Liontamer Protected Investments
27 October 2003
'Explosive' was the word used to launch the first ever CDO conference in Auckland on 9 October. Explosive growth of products and explosive growth in the market were the positive themes being referred to. And of course, there were also references to the potential toxicity of CDOs in the hands of retail investors, as well as the important message of understanding risk.
Now that the first few issues of retail CDOs (Collaterised Debt Obligations) have successfully launched (totaling a fairly impressive NZ$300+million) the conference was well timed. It was a good chance for those in the retail market to pause for thought and reflect on the early lessons. From the point of view of financial advisers, some critical debates sparked off:
The rating process?
It's increasingly complex and a rating doesn't give you a detailed understanding of a CDO, so don't rely on it too heavily. Two CDOs with the same rating can have quite different levels of sensitivity to default, because of the make-up of the basket of bonds.
Liquidity?
Two of the three retail issues in New Zealand have been listed companies and despite the recent nature of the issues, retail investors are already trading the shares. The message from the wholesale camp (those who have been buying CDOs for many years) was to be wary. These are not trading instruments and should be treated as a 'hold to maturity', plus they're tricky to value. If credit turns sour, liquidity dries up fast and it will be difficult to get out.
Static vs. managed CDOs, what's best?
It's a bit like arguing the toss between passive index trackers and an active fund, with some added layers of complexity
Valuations?
They are complex, a function of credit spreads, correlations, recovery rates, interest rates etc. So it's important to understand these intra-relationships.
Subordination and risk?
That's the buffer that protects you from initial defaults and it's crucial to understand the consequences of companies defaulting beyond this level, which acts as a 'safety net'. While unlikely on a historical basis, the downside risks are heavily geared once this initial protection level is broken. It's this factor which makes a CDO fundamentally different from a standard fixed interest investment.
Diversification?
Crucial for financial advisers to consider. The Macquarie and ABN AMRO issues had quite a large overlap in the basket of corporate bonds. These companies now acknowledge their future products need to be different.
Stress testing?
Another important research technique that the retail market must embrace. It simply means looking at the behaviour of the bonds in different scenarios to test how robust the CDO is. Things such as the effect of early defaults versus random defaults on returns are an example of stress testing.
And one of the most important questions of the day: "Can retail investors ever understand CDOs?" And the honest answer was "no - not now and probably not ever".
But the thought provoker was this - financially complex investments are being purchased by retail investors every day. The difference being, with those assets there are numerous researchers doing the analysis, advising the advisers and carrying out the important education process. That's where CDOs need to get to. Complexity isn't the issue, education and research is. The CDO egg has only just hatched and there's a gaping hole in the retail market at the moment. Advisory and research companies now need the support of the experts to make sure these instruments are sold responsibly and with knowledge of the inherent risks.
