In a class of their own
Many pension funds have invested in equities as a primary driver of returns and inflation protection, and fixed income for asset liability or cash management. Meanwhile, the returns offered by alternative-investment strategies (which have been competitive with equities) have driven their rapid growth, along with their diversification potential from traditional asset classes.
A collateralised debt obligation (CDO) has two aims: first, to offer returns that can compete with equities and alternative investments, but with risks concentrated on credit performance, rather than interest rates, earnings, liquidity or other variables generally affecting stock and bond prices; and secondly, to address some of the specific investment objectives of pension funds.
By adding CDOs to strategic asset allocation, pension funds can take leveraged exposures to credit and benefit from an expanded set
of risk/reward outcomes, which enable them to improve their efficient frontier.
CDOs are structured finance vehicles set up specifically to take advantage of an arbitrage that exists in the fixed income market. The arbitrage opportunity arises from the difference in yield between (i) the cash flows produced by a pool of diversified assets and (ii) the liabilities issued to finance those assets.
CDOs use securitisation technology to segment CDO liabilities into multiple tranches at varying levels of subordination. Since the majority of the debt obligations are rated investment grade or better, the CDO can achieve a low cost of funding versus asset yield.
The liabilities are tranched into different risk profiles rated across the spectrum from AAA to unrated – the latter being the lowest tranche (the equity tranche). These tranches enable investors to choose their risk level within the capital structure.
Each series of notes pays a fixed spread, with the equity receiving all residual cash flows generated from the pool of assets on a current basis. For equity holders, it is an efficient way to attain a leveraged position on the underlying fundamentals of a given asset class (especially for those that are underinvested in credit). It is also a unique way for pension funds without the necessary infrastructures to gain exposure to a variety of asset classes, such as leveraged loans or asset-backed securities, which have demonstrated resilient stability and predictable cash flows, and which would not be accessible otherwise.
Unlike other alternative investments, the securitisation technology used in CDOs provides a rapid transfer of excess cash flow to the equity investor, as the original investment can be returned within four to five years of issuance. This front-loaded nature significantly reduces the volatility/average life of return for CDO equity investors.
The primary risk to a CDO’s ultimate return is exposure to credit losses. Returns are driven by the cash flow generated by the pool of assets and not on the market value of these assets. Returns are sensitive to the timing of defaults, with better returns in the case of back-loaded defaults.
The collateral manager plays a critical role in any CDO’s performance. Investors in all tranches rely on the manager’s selling discipline and ability to identify and retain creditworthy investments. A collateral manager with a deep understanding of the underlying credit fundamentals of each asset in the portfolio (who avoids or sells assets that will ultimately default) adds significant value, while a weak manager can destroy it.
A high disparity in performance is evident among the following different types of CDOs. However, three guidelines can help to make for a successful CDO:
q The asset class needs to deliver predictable and stable cash flows, where the quality of these cash flows does not fluctuate in market downturns;
q The structure needs to give sufficient flexibility to the manager in order to mitigate the volatility of the asset class and allow the manager to pass different cycles of the asset class without having to ‘fight against the structure’ rather than managing the asset class;
q The management style of the manager has to focus on the most stable part of the universe (ie, those that are going to pay their cash flows), while mitigating the risk of principal losses and rating downgrades. There is no benchmark or need to invest in an outperformer to reduce tracking error, and CDOs are less exposed to mark-to-market risks. The objective is to produce absolute returns.
CDOs provide investors an opportunity to participate in a leveraged fixed income portfolio. As such, they provide a way of ‘slicing and dicing’ the risk/return characteristics of an existing asset class to create a range of investments with higher or lower risk structures. Furthermore, investors in the different classes of CDO debt
can benefit from asset-class diversification and access to management expertise.
Benefits also include:
q Relative value for senior debt buyers;
q Risk/return profile at the mezzanine level;
q Absolute expected returns at the equity level, with a lower standard deviation.
Expected rates of return on CDO equity range from 13% to 15% for new issues (for both leveraged loans and ABS), putting CDOs at the high end of the spectrum and comparing very favourably with hedge funds or other alternative investments.
Furthermore, CDOs offer little or no correlation to hedge funds or private equity, while producing a more stable and regular income stream, hence an improved efficient frontier.
Although CDOs are not totally immune to credit risks, they are structured to minimise their impact. For example, unlike many private equity investments, CDO equity provides relatively high up-front cash returns, significantly reducing the volatility of returns for equity investors.
CDOs are transparent to investors, especially when compared with private equity or hedge funds and they are reviewed regularly by ratings agencies and obliged to provide large amounts of ongoing data. There is now enough historical performance data on CDOs to show a lack of correlation between the equity of a CDO and traditional equity portfolios or alternative investments.
The combination of high returns and low correlations with equities and bonds suggests that CDO equity can play a valuable role in enhancing the efficient frontier curve by reducing the portfolio volatility. The low correlation between CDO equity and most other investment assets reflects fundamental structural differences. CDO equity is neither a market
play nor a ratings play; it is a pure credit play on diversified and granular portfolios.
Low correlation to broader markets makes CDOs an alternative fixed income asset class whose performance mirrors the CDO’s manager’s strategy, rather than macroeconomic factors. The most significant drawback is moderate liquidity, although this should be less important for pension funds, given their longer term investment horizons.
Given the high return and low correlation with fixed income, equity and other alternative investments (such as hedge funds or private equity), CDO investments present a strong case for pension funds to optimise their portfolios. Including CDOs in the overall asset-allocation strategy can increase diversification or improve returns while maintaining low volatility.
Alternatively, participating in a fund of CDO equity tranches through experienced managers enables a pension fund to diversify across underlying credit markets, CDO management styles and CDO vintages. This route, therefore, reduces the probability of extreme events, leading to more stable risk-adjusted expected returns and could help to mitigate some risks inherent to CDO equity.
Laurent Cezard is senior structurer, structured finance division, at AXA Investment Managers