Collateralised debt obligations (CDO), like those at the centre of the recent meltdown by Australian hedge fund Basis Capital, are being used by investment managers that do not understand them, according to a leading investment banker.
Sydney-based Merrill Lynch banker Peter Opie said it was not just retail investors that did not possess the technical ability to trade in CDOs, but many of the sophisticated institutional investors and asset consultants too.
"I don't think they truly understand the risk. They have good return profiles in good markets, but they have equally poor risk profiles in bad markets. Investors fail to understand that they can actually end up losing more than the principal if enough components of the CDO fall over," Opie said.
CDOs contain debt instruments with varying degrees of risk. The riskiest contain non-investment grade bonds or junk bonds and are referred to as equity.
Schroders head of fixed income Simon Doyle said investors were clearly attracted by the high yields on offer, given the lack of a return in more traditional defensive assets.
"By treating their exposure to these types of assets as being quasi-defensive, investors failed to properly value the risk premium required for the underlying liquidity risk and downside risk potential of these structures - or more likely they simply didn't appreciate that this risk existed," Doyle said.
An underlying default in one of the lower-rated, higher-leveraged tranches can cause a CDO to start to unravel.
"Typically a CDO may have 200 bonds. If one defaults, the coupon may go from 12 per cent to 5 per cent," Opie said.
"If there are two defaults, you may not get a coupon. If three unravel, you are at risk of losing capital and, roughly, if you have five defaults all your capital is gone."
He said he thought CDOs were a legitimate asset class when used properly, but they were just not well enough understood.
Basis Capital recently informed investors that its Basis Yield Alpha Fund lost around 14 per cent in June, while its Basis Pac-Rim Fund dropped 9.2 per cent.
