Collateralized debt obligations need to become more transparent if European pension funds are going to invest, but if they do the potential rewards are huge. Nick Horsfall, a specialist in asset allocation for bond related products at Watson Wyatt in London, predicted that the top 20 funds would eventually put between 2.5-5% of their assets in CDOs if they were more transparent. This equates to GBP5-10 billion (USD7.9-16 billion) in the U.K. alone.
"CDOs are horrendously lacking in price transparency," said Horsfall. He added that many pension funds have turned the instruments down for this reason. Comparing CDOs is an onerous task, Horsfall noted, adding that he analyzes deals by looking at the latest 20 structures to hit the market. "This is comparing apples and pears, but it helps," he explained.
The BT Pension Scheme is the largest in the U.K. and is actively studying CDOs. "The concept is reasonable," said Mike Carter, head of fixed income investments for Hermes Pensions Management, which is owned by BT. He added, "It is a question of being shown ingredients that are acceptable." The GBP25 billion pension fund would use the products as a way of increasing its bond exposure, likely investing in the lower ranking investment-grade notes. Carter said there is a huge amount of due diligence that needs to be done on each deal and spreads would need to widen before it executed its first trade.
"The single most important issue is education," according to Gareth Derbyshire, executive director in the sellside pension group at Morgan Stanley in London. Amanda Walker, director for finance and investment at London Pensions Fund Authority, which has around GBP3 billion in assets, said it is educating itself about these products. "I am not going to invest in anything I don't fully understand," added Walker.
Derbyshire thinks pension funds are well suited to take advantage of CDOs. The fact CDOs are illiquid means they pay an illiquidity premium, of which long-term investors, such as pension funds, can take advantage. A secondary market would enable the funds to get out of their positions, but would also reduce coupons.
