Kiwis lose their taste for exotics after Parmalat

Michael Coote

Friday 30th January 2004

The year 2003 saw the rise of exotic retail investments in New Zealand.

Principally these were capital-protected products and CDO bonds. The latter are a fairly new species of investment. The former have been around for a while, such as the OM-IP series. What was unusual was the flood of such investments and the large amounts of money they raised.

Conditions that made these exotics popular were a combination of prolonged poor international equity market performance and low central bank interest rates.

Falling interest rates were at first bullish for bonds but reduced the initial appeal of term deposits as a safe haven against the uncertainties of shares.

New Zealanders are suckers for yield, while at the same time averse to losing money.

The contradictory aims of seeking high reward with low risk predispose them to demanding products designed ostensibly to these ends.

The common feature of the exotics is that they involve some degree of insurance as part of their purpose.

With capital-protected products, investors insure themselves against future capital loss by having some portion of their funds placed in a compensation mechanism such as a zero coupon bond, or managed money account, or long-dated options.

This self-insurance comes at a cost and diverts funds away from the growth part of the construct, be that a hedge fund portfolio or stockmarket derivatives.

CDO bond investors are insuring others from capital loss namely higher-ranking securities holders within a subordinated debt structure. CDO structures are used to indemnify potential credit defaults in an underlying "reference portfolio" of corporate bonds.

As default events rise in the reference portfolio, trigger points are reached at which capital invested in CDO bonds is required to make good the losses of third parties. The lower the credit rating of a CDO bond within its subordinated series the closer it is to a trigger point at which it is liable to indemnify capital losses.

Vulnerability of CDO bonds was evident with the financial crisis in Italy's dairy company Parmalat last December.

The firm had issued many corporate bonds that in turn appeared in reference portfolios of CDOs.

When Parmalat packed up, so did its bonds and, by a ripple effect, CDO bonds linked to Parmalat felt the shock, including some issued last year in New Zealand.

The result was a drop in credit rating and market value of the CDO bonds.

The lesson was a quick one for New Zealanders insofar as issuers of CDO bonds usually calculate that defaults are not likely to occur within the first two years or so, in which time issuers make their money on the equity portion of the CDO structure.

But the system is not foolproof, as the Parmalat incident showed.

It remains to be seen whether 2004 will be as favourable to exotics as 2003.

One moot point is whether New Zealanders really understand what they are buying, particularly in CDO bonds, and whether they will tumble to the fact that they are behaving more like insurers than investors when they are putting up their funds to cover losses to themselves or others.

The general economic recovery environment is not so benign for products structured around competing demands of high return and low risk.

The same low interest rates that whetted investor demand for exotics have caused the terms of these investments to lengthen out to periods of seven years.

Reference portfolios underlying CDO bonds have expanded in size as corporate bond yields have fallen.

The best time to buy CDO bonds has passed as the risk of corporate bond default has declined due to improved economic conditions, contracting bond yields accordingly.

With international equity markets on the rise again, more conventional investments may regain appeal.

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