J.P. Morganis advising potential investors in collateralized debt obligations of what it calls an alternative means of evaluating structured credit vehicles. Most deal-marketing materials predict an investor’s rate of return by looking at the constant annual default rate of the underlying assets, but J.P. Morgan believes these are unreliable predictions because there are a wide range of default scenarios. “There’s an enormous range of variation for [return] scenarios with the same average default rates,” said Peter Rappoport, managing director and head of the quantitative strategy group.
Instead, he is advising investors to make investments based on their desired internal rate of return and the probability of that return coming to fruition. The main difference between his way and market convention is he looks at a whole spectrum of potential returns driven by the likelihood of different default scenarios, rather than just an average scenario. Rappoport said it is important for investors to properly evaluate CDOs now, particularly equity classes, because the tranches can be an attractive, relatively safe option in an environment where forecasted returns on traditional equity investments are not thrilling. Rappoport plans to present his method to a broad audience next month at the Bond Market Association’s CDO Investors conference in New York.