Brent Sheather: Low risk, yeah right

Investment trends come and go - five years ago "growth" was good and dividends were for losers.

Today, growth stocks have been exposed as a huge confidence trick and investors are falling over themselves for cashflow. It is something of a chicken-and-egg scenario as to which came first - the products or the fashion - but the fund management industry is quick to accommodate changing trends.

Yesterday's technology funds stressing growth have been replaced by extra yield funds boasting better returns than the bank without high risk. But is this yet another misallocation of capital in a different guise? The high returns description looks fair enough but common sense makes one look twice at the "low-risk" claim.

If there is one truth in investment markets, it is that high returns inevitably occur with high risks. But the day of reckoning for these "high-income, low-risk" products may be looming as evidenced by warnings from several sources including Alan Greenspan and Warren Buffett. What these luminaries are worried about is collateralised debt obligations or CDOs as they are known.

What do warnings about highly leveraged debt instruments typically frequented by the likes of hedge funds have to do with mum and dad in Tauranga? Quite a lot it seems, despite the fact that mum and dad and, it might be said, their advisers, are possibly oblivious to the unfolding scenario.

The connection is that CDOs are apparently one of the favoured vehicles for hedge funds in the US and high-yield funds locally. The brochure for one such fund popular locally to the tune of some $85 million worth held by small unit holders declares that 78 per cent of its money is invested in global structured securities (GSS).

Not being familiar with the term, I asked an adviser who had promoted the product just what a GSS was? Surprisingly, he didn't know but assured me that whatever it was it had a much higher yield than the bank, which was about all his clients were concerned with.

After reading the investment statement, it transpired the global structured securities in question were a portfolio of CDOs. Now there is nothing wrong with CDOs providing you understand what they are, how they work and which part or tranche you own*.

A useful first step is for mum and dad to know that they have actually bought one of these things. Sadly many seem unaware of just how their fund manager is producing a 9 per cent return after deducting about 2 per cent in annual fees including a 0.5 per cent pa trail fee. They may be about to find out.

Possibly, the best way of appreciating a CDO's unique risk profile is to consider its sensitivity to "credit events" - a company going bust. The bottom line is how many credit events can your CDO sustain before you lose your money?

With 100 different corporate bonds in one CDO, my uninformed guess was all 100 would have to go bust before you lose everything, right? No, not even close and, herein, is how the risk in "risk and return" peculiarly applies to CDOs: the essence seems to be that it is a leveraged debt instrument which is typically cut into pieces - these are called tranches.

The safest tranche might tolerate 10 company defaults until clients lose their principal whereas the riskiest tranche, sometimes referred to as toxic waste, pays the highest interest rate but might only be able to sustain four or five defaults. So which tranche does mum and dad own - toxic waste or AAA?

Have any credit events already occurred? Good questions but on the basis of the current level of disclosure there is no way of knowing, until perhaps something bad happens.

Now here is where Alan, Warren and the others come in.

US regulators are getting worried about the CDO market particularly since General Motors and Ford's debt was downgraded to junk a couple of weeks ago. The significance of GM and Ford to our story is firstly - between them - they have US$453 billion ($635.5 billion) in debt and, secondly, automotive debt is "widely referenced" in CDO structures. Rumour suggests that several hedge funds have sustained big losses in the CDO market as a result of the Ford/GM downgrade.

While neither Ford nor GM has gone bust, the debt downgrade is a very big deal. The Financial Times estimates that so far this year the value of GM/Ford's debt has dropped by US$32 billion. For comparison, when Enron went bust its total debt was US$23 billion. The president of the New York Federal Reserve in a recent speech suggested that the robustness of structured credit instruments has not yet been tested in an extreme credit environment. Greenspan adds that "some products will not have been adequately tested by market stress" and noted that interest rates are very low.

What happens if interest rates rise and investors suddenly become risk averse? Buffett, the world's most successful investor, refers to CDOs as "weapons of mass destruction". Other commentators say that, while on the basis of historical experience six credit events is highly unlikely so that the XYZ CDO is as safe as houses, in bad markets correlations increase and a problem in one sector could spill over to others. Ominously, the investment statement of one local CDO-based fund says redemptions can be suspended should the need arise.

Last month, the Financial Times said as GM and Ford are the two biggest names in the CDO market, investors "should be asking their managers plenty of what if questions". For mum and dad here "Do I have exposure to CDOs and how many credit events before my principal is impacted?" might be a good place to start.

* The Macquarie and ABN AMRO listed CDOs set out this information clearly in their prospectus.

* Brent Sheather is a Whakatane-based financial adviser.