Defensive asset class gives impetus to CDO market

There is no sign of a slowdown in demand for collateralised debt obligations (CDOs) from European investors despite mounting concerns over the credit ratings of corporate bonds and the high-profile collapses of WorldCom and Enron. The size of the global CDO market has now gone through the half a trillion dollar barrier and it was the fastest-growing asset class in Europe’s structured finance market in the first six months of the year, as it increased by 41 per cent to e74.4bn. A CDO is a special purpose vehicle (SPV) that owns a diversified pool of assets and issues several classes of securities. For each class of security, the payment of interest and repayment of capital is determined by the performance of the underlying securities. Despite the unrelenting growth in this market, Sandra Wong, vice-president of the structured credit solutions group at JPMorgan in London, says that in response to rising defaults in the bond markets, investors are seeking more defensive CDO structures and underlying investments. Prudent levels of leverage Ms Wong highlights the fact that JPMorgan, for example, recently issued the first European CDO that invests in asset backed securities to meet this demand for lower risk structured products. “We use prudent levels of leverage in the CDO of asset backed securities of eight times and have achieved resilient levels of return.” Asset-backed securities, including mortgage bonds, are regarded as liquid and relatively low-risk investments. “Asset backed securities provide investors with more stable returns and less volatility,” adds Ms Wong. She says it took JPMorgan six to nine months to collect 60 to 70 underlying asset backed securities for its e300m CDO but only 60 per cent of its capital is currently invested. Ms Wong says the other 40 per cent of capital will be invested over the next year. “We will look to add the right liquid assets at the right opportunity.” European clients were keen to invest in the CDO because it gave them “leveraged access to asset backed securities and diversification”, according to Ms Wong. It is this demand for diversification across and within asset classes, she adds, that is driving the development of CDOs with new underlying investments, such as hedge funds and private equity, rather than corporate debt. Furthermore, CDOs that continue to invest in corporate debt, Ms Wong says, have been diversifying away from telecoms and insurance corporate debt, for example, because of concerns about rising credit risk and defaults. “JPMorgan issued a CDO in June that invests in hedge funds because it enables investors to gain access to alternative investments and to meet their demand for investments that are uncorrelated to stock markets,” says Ms Wong. She argues that the CDO market has shrugged off the negative publicity surrounding SPVs after the collapse of Enron earlier this year. Enron misled investors by inflating its earnings and growth figures by hiding billions of dollars of debt in SPVs. It has been reported that the US’ Financial Accounting Standards Board is considering clamping down on such practices by requiring the owner of the SPV to report its assets, known as consolidation. Discussions are still ongoing in the US over how to prevent such abuses of SPVs in the future and it is unlikely any conclusions will be announced for a couple of months. She adds that these discussions could lead to requirements for SPVs to have a certain amount of equity with third parties and consolidation. Whatever the outcome, Ms Wong is confident that JPMorgan will deliver the right structure for the right asset class for investors. The CDO market will continue to grow as investors seek greater diversification and access to leveraged asset classes that were previously out of reach. Simone Leontis