Is time right for specialized bond products?

Financial planners, investment advisers and others who provide advice to wealthy individuals say they will continue to use collateralized debt obligations, collateralized mortgage obligations and other exotic investments for their clients, according to a story in InvestmentNews last week. At first glance, that seems irrational, given the losses investors have suffered over the past two months. For many reasons, however, it makes sense, if the advisers use the securities as part of diversified portfolios. First, the risk inherent in these securities is being repriced. That is, the returns should be higher, on average, than they were before the subprime-mortgage meltdown began. Demand for such securities before then was such that the yield was driven down and the prices were driven up to the point where they were mismatched. The return was not large enough to justify the risk. One reason the credit markets froze for more than a week was that they were trying to calculate new prices for the inherent risks in these securities. The repricing was difficult because few knew how many subprime mortgages were in each CDO. It’s likely that the expected return is now, or soon will be, more than enough to compensate for the risk, because the market generally overreacts to bad news. Second, the investment banks that produce these credit instruments are busily reworking their financial models to produce better securities. The subprime-mortgage meltdown stress-tested the models, and it revealed serious flaws. The CDO problems also have stress-tested the financial models of the rating agencies. Although these agencies say their ratings of the asset-backed securities were accurate, they will be quietly refining those models. The result should be, if not more accurate ratings, more confidence in the ratings. One reason the credit markets froze is lost confidence in the ratings of the exotic securities. Further, both rating agencies and investors, especially institutional investors, are going to demand greater transparency before they resume investing in these instruments. Of course, these investments still will not be sure things. They will remain riskier than most other fixed-income securities. But they should be used only by advisers who understand the risks and have structured client portfolios to withstand volatility.