One of the well-promoted benefits of CDOs is that they invest in a wide range of securities therefore there is safety in diversification.
Added to this many of the CDOs have credit ratings from agencies such as Standard and Poor’s and Moodys.
He cautions against getting too comforted by the diversification argument.
“The issue with CDOs is that the credit rating performance through an economic cycle is not going to be consistent with that of an ordinary, individual physical corporate bond.”
His other warning is not to get too comforted by the rating as the agencies treat CDOs differently.
Sneddon says the recent experience in the US and Europe is that the diversification benefits maybe overstated and that often CDOs can be heavily downgraded if there is just one or two of the securities in the offering which run into problems.
He describes the agencies as “aggressive down graders” of CDOs.
“A AAA rated individual corporate is likely to behave very differently to a AAA rated CDO.”
Sneddon says not all CDO-backed investments are bad, and there is a place for them. However, it should only be a small part of a portfolio.
He says there is still a place for a traditional, pooled managed fund as investors are getting good diversification, and they are investing in individual securities, each with their own credit rating.
“I would feel extremely uncomfortable if a retail investor in New Zealand took the view that I want to stay away from equities because that’s too risky I want to be in bonds because that’s more defensive and the best way to do that is to buy one or two CDOs.
“That to me sounds like potential disaster,” Sneddon says.
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