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Is There Room for CDOs at the Stable Value Inn?

As mixed economic signals continue to permeate the media, Stable Value assets are growing everyday. Is this to the delight of Stable Value asset managers? Not necessarily. As the cash comes in, some asset managers seem to be exhausting their exposures to traditional Stable Value assets: Agencies, Treasuries, Asset-Backed Securities (ABS) and Mortgage-Backed Securities (MBS), or are looking for new ways to add value. As MBS has had a home in Stable Value funds for some time, the extension of these securities, Commercial MBS or "CMBS," has become an accepted investment for managers and wrap providers alike over the past couple of years. While these four classes will no doubt represent the largest percentage of Stable Value funds' assets for years to come, managers definitely have room for exposure to investment-grade corporate credit. Enter Collateralized Debt Obligations or CDOs to the Stable Value inn. CDOs provide investors with an efficient approach to accessing broad exposure to investment-grade corporate credit.

Stable Value managers making allocations to corporate credit is far from a new strategy. Some managers turn to bond funds as a quick way to take exposure to the market. These managers will frequently tap a colleague down the hall, who runs a bond fund, for a portion of a Stable Value fund's bond allocation.

Since 1996, asset managers, banks and insurance companies looking to take exposure to diversified baskets of investment-grade credits, have used CDOs in size. The building blocks of CDOs are credit default swaps - the largest product sector in the CDO market. By some estimates, the credit default swap market now stands at $1.5 trillion. Arrangers of CDOs, typically banks and investment banks, use credit default swaps to reference individual corporate credits such as General Electric or IBM. Groups or baskets of credit default swaps are assembled and offered to investors as fixed or floating rate notes. A standard CDO note represents a distinct position in a static diversified portfolio of investment-grade credits.

CDO Note - Example for Illustrative Purposes Only

Note Face Amount:	$20 million
Legal Maturity:	5 years
Reference Portfolio Amount (100 credits, $10mm per credit):	$1 billion
Reference Portfolio Weighted Average Rating:	BBB+
Subordination for the Note:	$60 million (6%)
Note Rating (S&P):	AA+
Coupon (Quarterly, A/360):	3-month Libor + 1.40%

As highlighted above, the notes have five-year bullet maturities and can be overtly rated by S&P and/or Moody's. An added attraction, which can be seen in the above example, is that CDO notes give investors a pick-up in spread as compared to similarly rated debt. The pick-up in spread is attributable to the illiquidity of the notes and the fact that credit default swap spreads have not tightened as much as competing sectors. Looking at CMBS specifically, CDO notes have pick-ups of 103% in AAAs, 233% in AAs and 318% in As. For example, as of 8/22/03 A-rated CMBS earned 0.55% while A-rated CDO notes earned 2.30% for a LIBOR spread pick-up of 318%.

CDOs can add value for those Stable Value managers looking for or considering an alternative to Agencies, Treasuries, traditional corporate bonds, MBS, CMBS and ABS. Simply stated, asset managers buy a single note and gain exposure to 100 US and/or global investment-grade corporate credits. This task would be difficult to quickly replicate in the traditional corporate market. As Stable Value managers go through the due diligence process, they learn that CDOs allow for a great deal of flexibility. Investors can specify a desired rating, yield and/or notional size of the note they wish to purchase. While there is no requirement to do so, the notes purchased by Stable Value managers are typically rated by one or two of the rating agencies. Though most Stable Value funds' investment guidelines dictate that assets comprise only investment-grade paper (BBB-/Baa3 and above), CDO notes that have been purchased are rated A/A2 and above. The rating agencies rate CDO notes based on the quality and diversity of the underlying portfolio and the amount of subordination. The subordination amount provides an added level of protection for CDO note buyers as it absorbs losses in the event that defaults occur in the portfolio. So long as the underlying credits pay interest and the initial subordination amount exceeds total losses (if any), a CDO note will pay its stated coupon. This type of structure differs from those of bond funds. CDOs are cash flow structures and "funds," whether open or closed-end, are market value structures. The returns or yields generated by bond funds are derived from a manager's ability to pick solid credits and buying low/selling high. The returns or yields generated by CDOs are derived from selecting a diverse portfolio of credits and holding them over the life of the note.

While Stable Value asset managers can determine fairly quickly what their CDO note should be rated, a desired yield and the notional size, the process of selecting individual corporate credits for a portfolio can be daunting. This is why Stable Value managers have traditionally turned to bond funds. Some Stable Value managers do not have significant credit analyst teams to cover every corner of the investment grade market. Though CDO notes represent static or unmanaged portfolios, there are independent tools that enable note buyers to efficiently construct portfolios of corporate credits. These tools consist of various credit portfolio models and are usually provided by the arrangers of the CDO notes. Not all the credit tools currently available were created equal. The best credit models CDO notes buyers can utilize are those that are transparent, minimize subjectivity and are forward looking. Rather than relying on historical default rates and volatility, today's premier credit models take into account credit spreads and implied volatility from equity options. These forward-looking state-of-the-art models allow CDO note buyers to construct optimized investment grade portfolios with relative ease.

As cash continues to find its way to Stable Value funds, managers have increasingly looked at structured credit opportunities - CDO notes. Though traditional Stable Value investments will continue to dominate overall asset allocation, managers definitely have room for exposure to investment-grade corporate credit. CDOs provide investors with an efficient approach to accessing broad exposure to the asset class. Further, a CDO note provides a Stable Value manager with a great deal of flexibility (rating, yield, size, portfolio composition, etc.) and pick-ups in spread as compared to similarly rated debt. With all of these characteristics, there should be little doubt that there is room for CDOs at the Stable Value inn.

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