As damaging as it may be to our careers as financial analysts, we admit that we do not know what the future may bring. Furthermore, it seems to us that prognostications based on the most careful analysis of past economic experience may prove incorrect in the face of today’s potential for dramatic political events. To put it succinctly, politics (at least big- enough politics) trumps economics. Those few who share our uncer- tainty should consider CDO equity as a defensive investment.
Here is what we mean. Rather than invest $100 in high-yield loans or investment grade ABS on an unlevered basis, the concerned investor should consider purchasing CDO equity that controls $100 of those
EXHIBIT 18.9 After-Default Cash Flow Volatility
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assets. The remainder can be stored in whatever safe harbor asset one prefers.
The resulting risk profile will not have all the upside potential as if one had dedicated his portfolio completely to the CDO’s underlying assets. But the downside risk will be significantly mitigated.
CONCLUSION
We have tried to answer the question “Why buy CDO equity?” with four arguments.
First, nonrecourse term financing is a very good thing. The “heads I win, tails I don’t lose everything” bet sets a floor to the downside of lever- aged investing. An investor cannot lose more than the initial investment.
Second, the forgiving nature of the cash flow CDO structure further enhances equity holder’s return if CDO assets underperform. This feature is especially pertinent when an investor expects a period of continuing low defaults and high recoveries before any CDO asset deterioration.
Third, the ability to sell out early or wait and see gives CDO equity holders flexibility to take advantage of market value appreciation and delay the effects of credit quality deterioration.
Fourth, CDO equity can be used in conjunction with a safe harbor asset as a defensive investment strategy for those who are unsure of future economic conditions.
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CHAPTER 19
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CDO Equity Returns and Return Correlation
here has been a good deal of research published on historic CDO equity returns, particularly with regard to the monthly volatility of equity returns, their Sharpe ratios,1 and the correlation of CDO equity returns to the returns of other assets. Unfortunately, the calculation of these variables is so fundamentally flawed that the results that have been reported to investors are useless. The reason is quite simple: The secondary market for CDO equity is undeveloped. As a result, there are no monthly prices for CDO equity. It follows that one cannot calculate monthly CDO equity returns, the monthly volatility of CDO equity returns, or a CDO equity Sharpe ratio. Nor can one correlate monthly CDO equity returns with those of other assets.
In this chapter, we investigate what part of the historic record has any bearing on future CDO equity returns. We conclude that the only historic data that provide insight into the future performance of CDO equity are the default and recovery of underlying CDO assets. Conse- quently, this limits the usefulness of the historic CDO equity return measures mentioned above, even if they could be calculated reliably.
We then make the most of available default and recovery data to examine the implication to CDO equity created in today’s environment with either high-yield loan or structured finance underlying assets.
Next, making some simplifying assumptions, we show that the correla- tion between CDO equity returns and CDO underlying asset returns is a simple function of the levered and nonrecourse nature of CDO equity.
1 The Sharpe ratio is the monthly return on CDO equity minus the risk-free return divided by the standard deviation of monthly CDO equity returns.
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An understanding of CDO equity return/CDO asset return correlation can be gained without an appeal to dubious data and calculations. And once we correlate CDO equity returns to the CDO’s underlying assets, it is simple to correlate CDO equity returns to the returns of other assets.
Finally, we circle back to the simplifying assumptions we made to correlate CDO equity returns to the returns of other assets. We show that these assumptions underestimate CDO equity returns and overesti- mate the correlation of CDO equity returns to those of other assets.
Thus, if CDO equity appears to be a good addition to a portfolio based on the assumptions we made earlier, it is in fact a better addition to the portfolio once we relax those assumptions.