Why Highly-Rated CDO Tranches are a Bad Bet

Lets's say you are given a choice between two AAA-rated bonds. Both have the same probability of default, which is very low. But Bond X defaults pretty randomly, while Bond Y defaults only during times of economic catastrophe. Which would you prefer? There is a right answer, and it's Bond X. Here's how Joshua Coval, Jakub Jurek, and Erik Stafford put it in a new paper:

Securities that fail to deliver their promised payments in the "worst" economic states will have low values, because these are precisely the states where a dollar is most valuable. Consequently, securities resembling economic catastrophe bonds should offer a large risk premium to compensate for their systematic risk.

One of the perennial debates in the credit markets is whether asset-backed securities with strong credit ratings can really be considered just as safe as single-name unsecured credits. The answer depends to some extent on the asset-backed security in question. But if you look at the highest tranches of CDOs, especially synthetic CDOs, they often default only in extreme economic circumstances, when a lot of companies all default at once. Which is exactly the kind of circumstance when you want your triple-A paper not to default. For this reason, such CDOs really do resemble "economic catastrophe bonds," which pay out a steady coupon unless and until catastrophe hits, at which point they tend to lose all their value.

The interesting thing is that if you want an economic catastrophe bond, you can construct one just as easily by writing something known as a "deep out-of-the-money put spread" on the S&P 500. If you write an out-of-the-money put, you're offering to buy the index at a level far below its present value at some point in the future. A put becomes a put spread when you hedge that exposure by buying an even deeper out-of-the-money put, thereby putting a cap on your possible losses.

In the vast majority of situations, the index will not have crashed to well below its present level by the time your put expires, and you get to keep the money you got from writing it. If there's an economic catastrophe, however, you can lose a large chunk of money. So deep out-of-the-money put spreads act like economic catastrophe bonds – but, according to the new paper, they are much, much more lucrative.

An investor willing to assume the economic risks inherent in senior CDO tranches can, with equivalent economic exposure, earn roughly 3 times more compensation by writing out-of-the-money put spreads on the market.

I wonder: is there some kind of ETF whose strategy is simply to write such puts? It sounds like an attractive alternative to some of the fixed-income investments which are presently being offered.

(Via Alea)