| Moody's expects a rating boom in Collateralised Fund Obligations |
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| 18/03/2007 | |
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Collateralised Fund Obligations (CFOs), whose underlying collateral is a fund of hedge funds, are likely to gain greater acceptance among fixed-income investors this year. Moody's rated 5 CFOs in 2006. It expects to rate at least 10 more this year. The first CFOs were structured by CS First Boston and JP Morgan in 2002. Today, the structured product has gained greater acceptance with the proliferation of hedge funds, providing bond investors access to the hedge fund world. Société Generale Asset Management (SGAM AI) closed its first €200m CFO Premium deal recently with a five-year scheduled maturity. The liability side of this CFO is similar to the one of a classic CDO, with four debt tranches from Aaa to Baa2 in addition to an equity tranche. The deal was distributed to traditional CDO investors and hedge fund specialists. The aim is to offer enhanced returns in today's tight spread environment, says Steven Le Moing, Head of CDO and Structured Products at SGAM AI. The leveraged exposure in the current interest rate environment is another factor driving CFO demand, according to Le Moing. Wider CFO spread Structured product specialists estimate that a triple-A rated CFO tranche offers 45bps over comparable treasuries, while the spread for a cash CLO (a CDO based on a portfolio of loans) is around 20-22bp. CFOs may offer a higher yield, but they also present a number of risks. Among them: redemption frequency (funds are redeemed only at periodic intervals making them illiquid) and a lock-out period. In addition, CFO investors must feel comfortable with the opaque nature of hedge funds which constitute the underlying collateral. As a result, investors may face "rapid total loss of any single hedge fund due to inaccurate reporting of Net Asset Value (NAV)," says Fabian Astic, a CFO analyst at Moody's. How does Moody's rate a CFO? "We define the worst case portfolio," says Astic. "We apply some stresses to the historical correlations and volatilities for the underlying strategies and simulate the portfolio behaviour, taking into account the liquidity profile covenanted in the CFO documentation (the idea is that although the liquidity of the underlying hedge funds is hard to assess, there is a global profile which appears in the legal documentation of the CFO that triggers the redemption of the notes when breached). We then put the cash flows generated by the portfolio of hedge funds in the waterfall that represents the priority of payments. This waterfall takes into account market value tests that protect the rated notes. The tests ensure that the Special Purpose Vehicle has enough money at its disposal to repay the notes when needed. For each such simulation we obtain the loss on each tranche and reproduce this process for a high number of simulations and compute for each tranche the expected loss posed to investors at the maturity date." This is why diversification and strategies across a wide range of hedge funds is important in reducing portfolio volatility. The two dominant CFO risks are a lack of transparency and potential illiquidity. "Our rating criteria may help in terms of liquidity. The lack of transparency is mitigated by the expertise of the fund of hedge funds manager that should have a good track record," says Astic. "The portfolio needs to be diversified in terms of strategy and hedge fund managers. Otherwise, we would face the risk of having a single manager using many strategies and the potential bad performance of this manager would have a very negative impact on the transaction." In addition, Moody's assigns Operations Quality ratings to hedge fund managers. Such ratings (either issued on a public basis or internally) are used in the analysis of a CFO. Typically, the most senior CFO tranche accounts for 45% of the deal. In the capital structure of a CFO, the most important tranche is the equity portion. VB |
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