Structured finance investors chasing higher yields have been piling on leverage through vehicles known as CDO squareds.
The increased leverage can increase returns, but it can also bring risks. The vehicles invest in a pool of collateralized debt obligation tranches, which are securitized pools of other assets. The underlying components for CDO squareds are typically synthetic CDOs based on a pool of credit default swaps.
The volume of synthetic CDO tranches distributed and purchased by investors last year rose 52.9% from 2003, to $260 billion, according to J.P. Morgan Chase & Co. research. While no breakdown is available, JPMorgan Chase researchers estimate that CDO squared issuance more than doubled last year.
"In many ways, a compressed spread environment is going to require that investors try that much harder to increase their returns. One of the ways is leverage," said Jim Ballentine, the global head of structured credit at Lehman Brothers in New York.
Returns were skimpy last year on all types of corporate debt, from asset-backed securities to unsecured corporate bonds. Those returns prompted all types of investors - including hedge funds - to search for higher yields.
"Hedge funds have promised their investors outsized returns, and they're exploring further complicated and esoteric strategies and products, such as CDO squareds," Mr. Ballentine said.
Mike Hennessy, a managing director with Morgan Creek Capital Management, a Chapel Hill, N.C., company that invests in hedge funds, said more funds jumped on the CDO bandwagon last year - some of them simply to add leverage.
One of the main risks in CDO squareds relates to the limited world from which structured finance products are drawn. CDO squareds and their underlying CDO tranches may contain some of the same corporate debt.
That means that if a frequent issuer of corporate debt defaulted, and the credit default swaps on the issuer's bonds widened sharply, the effect on a CDO squared could be magnified, because that issuer's default swaps could be in more than one of the tranches used to build the CDO squared.
"There is a higher level of correlation between single-tranche CDOs being referenced than there is with the underlying corporate names in a CDO," said Mike Gerity, a senior director with Fitch Inc.'s credit products rating group in New York.
And a widespread selloff in corporate bonds and credit default swaps could have a nasty effect on CDO squareds. "It's like a rubber band that is wound very tightly. If it snaps, it will unwind violently," Mr. Ballentine said.
Another risk involves foreign demand for U.S. corporate debt. The dollar's recent declines against the euro and the yen are widely expected to continue in the coming months.
"A weakening dollar could prompt … Asian investors to transition to euros or yen-denominated assets" and cause U.S. credit spreads to widen, said Andrew Feldstein, a managing partner of the credit-focused hedge fund company BlueCrest North America.
