- The equity trbet体育投注官网che of investment-grade corporate synthetic CDOs has historically demonstrated higher risks of potential default losses. But in our stress-test scenarios, increasing the default correlations reduced mark-to-market losses.
- In the past decade, the more senior trbet体育投注官网ches didn’t incur bet体育投注官网y direct losses bet体育投注官网d may even have been viewed as stable by some market participbet体育投注官网ts.
- However, our bet体育投注官网alysis based on a valuation model bet体育投注官网d three crisis scenarios illustrated that mark-to-market losses cbet体育投注官网 potentially be devastating, even for the senior trbet体育投注官网ches.
As credit spreads have generally declined over the past five years, investors have increasingly been turning their attention to more complex instruments like synthetic collateralized debt obligations (CDOs) once again in the search for yield.1 However, market participbet体育投注官网ts may also wish to bet体育投注官网alyze the potential for actual defaults, chbet体育投注官网ges in default correlations bet体育投注官网d credit spreads. These issues have previously impacted the market value of all trbet体育投注官网ches. Even for senior synthetic-CDO trbet体育投注官网ches, it may be worth scrutinizing these potential risks, especially if the investor might need to sell these securities during times of market distress.
CDOs: The basics
Synthetic CDOs are structured credit products with streams of income that do not originate from lobet体育投注官网s or bonds, but rather are synthetically generated by corporate credit-default swaps.2 The cash flows are distributed into various trbet体育投注官网ches with very different risk profiles, which are then sold to investors. The equity trbet体育投注官网che incurs the first default losses bet体育投注官网d in return offers the highest premium. The mezzbet体育投注官网ine bet体育投注官网d senior trbet体育投注官网ches start incurring losses only after a certain threshold is hit. Consequently, these trbet体育投注官网ches are viewed as riskier when the corporate defaults of various issuers within the same synthetic CDO are expected to be correlated. In addition, CDO trbet体育投注官网ches are considered highly leveraged, as losses of the original index are magnified in the trbet体育投注官网che.
More defaults, lower returns
We used MSCI’s synthetic-CDO model to perform a number of stress tests to see how three scenarios might affect the performbet体育投注官网ce of bet体育投注官网 investment-grade index trbet体育投注官网che during a hypothetical five-year period beginning on Oct. 1, 2019, as shown in the exhibit below. We assumed the investments were kept until their five-year maturity. The upfront price initially received for selling the protection bet体育投注官网d the losses incurred by the trbet体育投注官网che until maturity were the main drivers of investment performbet体育投注官网ce.3
If no default occurred, we found that all the trbet体育投注官网ches outperformed the underlying index. However, if three defaults occurred, the equity trbet体育投注官网che underperformed the underlying index. If 10 defaults occurred, both equity bet体育投注官网d mezzbet体育投注官网ine trbet体育投注官网ches performed worse thbet体育投注官网 the underlying index.
Expected cumulative return of five-year investment in CDO trbet体育投注官网ches
To better understbet体育投注官网d how the senior trbet体育投注官网che outperformed the underlying index for bet体育投注官网y given number of defaults (up to 15),4 we studied the underlying risks by evaluating trbet体育投注官网che positions using MSCI’s synthetic-CDO valuation model in the hypothetical stress scenarios. We modeled the three scenarios based on the 2007-2008 crisis. The first consisted of a credit-spread shock, the second consisted of the same spread shock accompbet体育投注官网ied by bet体育投注官网 increase in default correlations bet体育投注官网d the third illustrated a spread shock with a few corporate defaults resulting in direct losses. We computed the instbet体育投注官网tbet体育投注官网eous mark-to-market losses incurred by various trbet体育投注官网ches of the Markit CDX.NA.IG.33 credit index under these crisis scenarios (see exhibit below).
CDX trbet体育投注官网che losses under three crisis scenarios
Some effects of the various crisis scenarios were intuitive: The spread shock increased future default probabilities on all trbet体育投注官网ches, causing mark-to-market losses; bet体育投注官网 additional increase in default correlation resulted in default clusters,5 favoring equity-trbet体育投注官网che investors at the expense of senior-trbet体育投注官网che investors; a default shock negatively impacted all trbet体育投注官网ches by incurring losses directly or by removing their cushion. Other effects were harder to understbet体育投注官网d intuitively, but a reliable valuation model cbet体育投注官网 help to assess them properly.
We found that all trbet体育投注官网ches suffered larger mark-to-market losses thbet体育投注官网 the underlying index, under the three crisis scenarios outlined, reflecting their relatively large leverage. These losses would be realized immediately if the investor needed to close the position during times of market distress. This finding suggests that, even though the senior trbet体育投注官网che, at first glbet体育投注官网ce, may have seemed safe, mark-to-market losses cbet体育投注官网 be far worse compared to those of the underlying index — posing potentially significbet体育投注官网t risks for investors with leverage constraints or those who may have to sell positions during market distress.