Traditional collateralized debt obligation (CDO) investment structures may not be flexible enough to meet the objectives of all investors. CDO combination securities have arisen to address this need. Combination securities can be tailored for each investor based on the desired credit rating, minimum coupon, yield target, and capital guidelines.
The collateralized debt obligation market has provided investors with the ability to capture the benefits of a diversified portfolio of corporate bonds. The CDO, via its senior, mezzanine and equity tranche structure, allows the investor to participate in this diversified pool of assets at different risk-reward levels. For example, while the typical Aaa-rated CDO tranche in the market today may pay an investor LIBOR plus 45 basis points, an equity interest in the same CDO has an expected yield of 15%20%. However, the three-tiered investment structure may not be flexible enough to address the objectives of many investors.
For this reason, the firms have developed a class of structures called combination securities, whose return is derived from the cash flows of two or more underlying instruments, at least one of which is a CDO security. The number of possible combinations is infinite but the creation of any combination security starts with the simple question:
* What are a buyer's key investment considerations?
* Important investment guidelines include:
* Does the investor require a rating on the security?
* Does the investor require a rated coupon or yield
on the security?
* What is the investor's economic yield target?
* What are the investor's economic and regulatory
capital guidelines?
* Under what legal jurisdiction does the investor operate?
A combination security may be crafted to satisfy almost any investor requirement. The simplest form of combination security, the principal protected unit (PPU). A PPU is created by bundling a piece of CDO equity with a zero-coupon Treasury STRIP, or other security free of credit risk. These units are designed to protect investors from the loss of their initial investment while still providing the potential for attractive returns.
For example assume a buyer invests a total of USD45 million for the PPU, USD23 million of which is used to purchase the 12-year STRIP with a face value of USD45 million, and the remainder of which is used to purchase CDO equity. Even if the equity fails to return any cash flow, the STRIP will accrete to a face of USD45 million at maturity, and the investor will recoup the initial capital outlay. Moody's can rate this PPU triple-A for return of principal, which may allow some investors to gain preferable capital treatment under internal and/or external capital guidelines. The cost of this downside protection, however, is to sacrifice some of the upside potential. Since both CDO equity and a Treasury STRIP support the PPU, the STRIP will dilute expected returns and limit the return of the PPU when compared to an investment solely in the equity. Figure 1 compares expected returns on a CDO equity investment to a PPU investment in an investment-grade average CDO. In recent years, combination securities have evolved from the simple PPU to more sophisticated combinations. For these securities, several tranches of a CDO are combined in proportions that can be tailored to an investors risk/return appetite.
We quantify the trade-off between downside protection and this upside limitation using conventional constant-default rate (CDR) methodology and Salomon Smith Barney's Monte Carlo Simulation Method.
The ratings-based, CDR investment framework has limitations. First, two CDO combination securities can have the same rating, but substantially different return profiles. In addition, the CDR method assumes that default rates are uniformly distributed in the investment-grade and high yield rating categories. They are not. Third, combination security returns are critically path dependent, meaning defaults that occur early in the life of a transaction will impair an investment more than defaults occurring at the tail end. Finally, while the traditional methodology produces average returns for a given annual default rate, it gives no guidance to an investor regarding the dispersion or variability of returns around that mean.
We propose a refinement to the current market convention for pricing CDO combination securities -- a refinement based on Monte Carlo simulations and actual historical default rates. The method is a generalization of that which we reported earlier for analyzing investment grade CDOs. Our approach is to make no parametric assumptions about the underlying distribution, but rather to generate annual default rates for each pricing vector by sampling--with replacement--from the historical default rates published by Moody's since 1970. Accordingly, we randomly sampled from these annual default rates and constructed 2,000 default vectors that are a mix of front-, middle-, and back-loaded curves.
Results
For various combinations of rating, rated coupon, and percentage of equity tranche, we compute internal rates of return (IRRs) using the constant-default rate method and calculate both IRRs and Sharpe ratios using our simulations. Although both methods predict similar returns for the various combinations, only the Monte Carlo method allows us to calculate the relative risk-reward characteristics of each instrument.
Results confirm our previous work on investment-grade CDOs that securities, equity and otherwise, backed by pools of investment-grade bonds produce high expected returns and high Sharpe ratios under historical default scenarios. For example, our prototypical CDO equity has an expected IRR of 18% with a Sharpe ratio of 1.7, whereas an Aa2 rated combination security with 8% equity and a minimum rated coupon of 4% yields 8% with a Sharpe ratio of 5.0. Simulations based on 2x historical default rates decrease the yield on the CDO equity to 15% and its Sharpe ratio to 0.6, whereas the combination security's yield decreases to 7.4% with a Sharpe ratio of 2.3.
In general, we find a direct relationship between the expected IRR and the proportion of CDO equity in each security, but an inverse relationship between CDO equity and its Sharpe ratio. In addition, not all similarly rated combination securities produce equal expected returns and, in particular, may differ greatly in Sharpe ratios.
For any combination security an investor must decide how much yield to sacrifice for stability of return. Results from our sample of combination securities allow investors, based on their yield requirement and volatility tolerance, to determine the appropriate mix of senior, mezzanine and equity tranches supporting their investment.
Figure1
Expected IRR From CDO Equity Versus Principal Protected Unit
Source: Salomon Smith Barney
This week's Learning Curve was written by Glen McDermott, v.p. in corporate bond research, Terry Benzschawel v.p. in credit modeling and analytics, and Adrian Lui, associate in structured products, at Salomon Smith Barney.
