Monday 3 June 2019 10:13 am

‘Return of the CDO’ – how scary could that sequel prove?

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I’m an investment specialist on the equity value team at Schroders and an author on The Value Perspective.

I’m an investment specialist on the equity value team at Schroders and an author on The Value Perspective.

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CDOs 2 (complete, of course, with the tagline ‘Just when you thought it was safe to go back into collateral debt obligations’) is unlikely to have filmgoers queuing round the block – and yet ‘Overconfident group reckon they can do better than previous set of unfortunates in the face of all warnings and evidence to the contrary’ has been the basic plot of all manner of successful creature feature and horror movie sequels.

Certainly film follow-ups of varying quality, from Aliens to The Lost World: Jurassic Park, sprang to mind as we read a recent article in International Financing Review, entitled Banks, investors pile back into synthetic CDOs.

Given the small uptick in appetite for these products after years of decline since the financial crisis, that is a pretty punchy headline, yet some of the language in the piece sends a shiver or two down the spine.

A “growing demand from yield-hungry investors” is, almost inevitably, invoked before the article picks up on “the darkening outlook for returns in credit markets, epitomised by the trillions of dollars-worth of negative-yielding debt worldwide, which is prodding money managers towards more complex investments that promise meatier gains”.

The risks deserve a mention

The sort of risks that tend to accompany “meatier gains” do not receive much of a mention although the article does note “market veterans” drawing parallels with the years leading up to the credit crunch.

“Faced with meagre returns in corporate bonds back then,” it says, “traders decided to lever up their positions by slicing up portfolios of credit-default swaps into tranches with varying degrees of risk and return.”

Regardless of what happened a decade ago, however, some banks have been stepping up to meet the demand – apparently heartened by the view that the main issue back then was “the quality of the assets stuffed into CDOs, rather than the structure itself”.

“And despite the stigma of resembling other complex products that were consigned to the scrap heap,” the IFR piece goes on, “synthetic CDOs have survived and evolved.”

Read more:

We will do our best – for a moment – to stifle the thoughts of the lethal ‘Indominus Rex’ in rebooted franchise Jurassic World, which that sentence brings to mind, and instead return to a theme touched on plenty of times before in articles, such as The investment now giving central bankers the jitters: risk is building up across the financial system.


As ever, the problem is spotting precisely where – and it may well not be in the CDO sector at all.

After all, everybody there says they are well aware what went wrong last time and are taking the appropriate steps to make sure it does not happen again… Even so, when people are focused myopically on returns without much consideration for the associated risks, bad things happen.

And in markets, they really can hear you scream.

  • Andrew Williams is an author on The Value Perspective, a blog about value investing. It is a long-term investing approach which focuses on exploiting swings in stock market sentiment, targeting companies which are valued at less than their true worth and waiting for a correction.
 

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