HY-FY investors get a jolt

Investors in collatoralised debt obligation (CDO) backed investments learnt how quickly a credit rating for their security can be downgraded just before Christmas.

Wednesday, January 7th 2004, 12:01PM

Standard and Poors downgraded the credit rating on both tranches of the HY-FY Securities which were issued by ABN Amro to the public earlier in the year.

The Series 1 CDO, which is paying a coupon of 7% annually, was downgraded from AA – to A+ and Series 2, which is paying 8.75% annually was been downgraded from BBB to BBB–. The sudden downgrade was made after one of the 70 companies in the portfolio, Italian dairy giant Parmalat, defaulted on interest payments and subsequently was declared bankrupt.

Although HY-FY investors haven't lost money the Parmalat default has increased the possibility that they may lose some of their capital before the investment matures in four and a half years time.

Each tranche of these CDO backed investments have a level of protection built into them which is described as the percentage of losses a series can sustain before investors' principal is eroded.

In the case of HY-FY it is 5.5% and 3.68% respectively for Series One and Series Two.

Series Two investors are hardest hit as about 25% of their protection has been lost due to Parmalat.

If there are four defaults before the investment matures in August 2008 then Series Two holders will lose some of their principal. Series One, which has greater protection, can suffer six defaults before losses occur.

ABN Amro research manager Frank Jasper says he is "a little bit surprised" that this has happened so early in HY-FY's life. That surprise also comes about as Parmalat was on a positive credit ratings watch before it was downgraded.

Parmalat has also fuelled the debate between static and managed CDOs.

Research house Fundsource says the failure highlights the differences between static and managed CDO investments.

"Such events are also a clear indication of the disadvantages of retail investors investing directly in static (unmanaged) CDO structures."

It says that in a managed CDO the manager "can take active decisions on specific credit exposures and replace deteriorating credit as and when business and economic conditions change."

However, Jasper doesn't agree with Fundsource's arguments. He says a manager couldn't see the Parmalat collapse coming and so couldn't react. Also the returns in a managed portfolio are different as there are management fees.

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