Low interest rates on Treasury bonds and under performance in recent years have sent many investors toward alternative investments in search of a higher yield. Investors are, well almost, always aware that higher yield usually means a higher level of risk, but some instruments are not just risky for individual investors, they're risky for the entire market place.
One of those instruments appears to be making a come back.
According to a Businessweek article, Synthetic Collateralized Debt Obligations are making a come back. The instruments, which are held responsible for amplifying the effects of the 2008 financial crisis. They involve three parties, one to put the deal together, usually an investment bank, one to take the short position and another to take the long.
The party in the short position is betting that at least some of the securities referenced in the synthetic CDO will default, or undergo other specified credit events. The party in the long position is betting that this won't happen. The referenced securities can be anything from mortgages to credit default swaps. The parties are allowed to take any level of risk they agree to.
According to the Businessweek piece Citigroup Inc. (NYSE:C) sold $2 billion in all of 2012, but has already sold up to $1 billion worth of the notes so far in 2013. The market for the instruments is growing because corporate bond yields, and other debt instruments, have seen their yield fall to incredibly low levels.
One deal referenced in the article, which was organized by Citigroup Inc. (NYSE:C) insured against the default of 125 corporate bonds. If more than 7% of the pool was lost investor would be wiped out. That deal, and many others like it, were not rated by any agency.
Yields are down across the board, forcing hedge funds and other investment groups to go looking for more lucrative deals in order to insure they meet their targets. Synthetic CDOs work well when everything is fine; unfortunately, in bad times they can make things worse.
During the financial crisis synthetic CDOs inflated the amount of money invested in the debt market and allowed investors to assume huge unbearable levels of risk. When the housing market went belly up those losses hit investors hard, and resulted in huge losses.
The current low interest rate environment may be doing a reasonable job of keeping the U.S. economy ticking along, but it is also having side effects on investments.
Investors are willing to take incredibly high levels of risk, like that offered on synthetic CDOs, in order to meet their return goals. Corporate bond yields are returning less than equities. they're practically useless to investor seeking a return.
The level of risk in the investment world is, on a whole, rising because of this, and it may lead to dire consequences if regulators do nothing about it.