Inside the black box

The investment business produces its share of unlovely jargon, but there comes a time when the technical terminology is unavoidable.

So here goes: "collateralised debt obligation". There, we've said it, and if you enjoy dazzling listeners with your vocabulary, you now have a new weapon.

It's an ugly phrase but one that investors will be seeing more in future.

That's because collateralised debt obligations, or CDOs for short, play a big part in a new type of fixed-interest investment that claims to be able to deliver high returns without too much risk.

This week manager ING launched a fund which will put most of its money into CDOs, and several other managers are working on something similar.

Many investors will be happy to treat those offerings as a black box - put money in one end, take it out the other and who cares what happens in between?

But anyone who likes to know who is doing what to their money faces an immediate question: what is this mysterious thing called a CDO?

At its simplest, a CDO is just a collection of investments that pay interest. That collection can be large - maybe 50 or 100 separate investments - and its investments will usually be diversified across various industries and may come from several countries.

The idea is that while any one investment may be risky, if you have enough of them, the risks are more predictable. Some may go bad - for example, a company may default on its bonds - but the impact will be reduced because most of the investments in the pool will keep performing.

Those investments are assembled by a manager and held in a trust or some other legal structure. The manager then goes looking for investors who want to share the returns generated by all those investments.

The investors, who tend to be large institutions such as insurance companies, are offered a choice of returns. Those who want the highest rate will also face the most risk, because the CDO is set up so they will be the first to take any losses. Other investors may prefer a lower rate, knowing the fund will have to suffer many losses before their returns suffer.

The CDO structure has been around since the 1980s but has grown rapidly since the late 90s. In theory, it can offer better security than individual fixed-interest investments, because of diversification, because other investors are willing to take the first risks, and because the fund can include more than the investments it needs to pay the promised returns, to provide a safety cushion if something goes wrong.

Investments issued by CDOs are evaluated by the international credit rating agencies which decide whether they deserve an "AAA" (as good as it gets) or a lesser rating.

The new ING offering, the Diversified Yield Fund, will take New Zealand investors' money, put most of it into a variety of CDOs then pass the return back to investors. A big attraction is that the fund is based in Australia, meaning most New Zealand investors can enjoy their returns in the form of non-taxable bonus units.

The manager says it aims to beat the 90-day bank bill rate by 2 per cent a year, after fees and taxes. At today's interest rates that would mean about 7.2 per cent a year, which would be a handsome return indeed; if you're on the top tax rate, that's the equivalent of earning 11.8 per cent on a taxable investment.

ING says the CDOs it invests in will have an average credit rating of BBB. That is widely accepted as meaning "investment grade" - not as solid as Government stock, for example, but better than the high-interest offerings on the local market, most of which don't have a credit rating.

Because returns will be issued as bonus units rather than paid out, this is not a fund for those who want regular income. Neither is it a place to put money you may need in a hurry, since investors must give at least 30 days notice to withdraw money and withdrawals are processed on only one day a month.

The minimum investment is $1000.

For investors, the big attractions are the chance to earn a healthy return, and the Australian structure, which effectively turns income into a non-taxable (in most cases) capital gain.

Other pluses include diversification and the fact that the fund will insure against currency movements, so changes in the value of the kiwi dollar won't affect returns.

If those are the pros, the con is that CDOs are not a straightforward investment. Beyond the basic CDO, described above, there are some much more complicated variations. Some authorities have warned that some of the more exotic permutations can be particularly difficult to value.

Nor is a credit rating infallible; some CDO investments with solid ratings have produced losses for their investors.

The complexity of the market means investors will be putting their faith in ING's ability to choose good CDOs and to monitor their investments.

As part of that process, the company says it will do its own research, rather than just relying on the rating agencies.

* To contact Personal Finance Editor Mark Fryer write to: Weekend Herald, PO Box 32, Auckland. Email Mark Fryer Ph: (09) 373-6400 ext 8833. Fax: (09) 373-6423.