Underlying assets of structured products

Some structured products are invested in CDOs (collateralised debt obligations). These are described as their "underlying assets".

These underlying assets are NOT the same as the "reference entities" which are used to determine the additional return based on certain complicated formulas involving their share prices.

As the reference entities are large, familiar companies, many investors MISUNDERSTOOD that their money are invested in these entities (which is NOT the case).

CDOs are invested in bonds and mortgages of various quality (including subprime mortgages that are now seeing high default rates in USA). The manager re-packages the assets into various tranches of the CDOs, rated from AAA (least risky) to the equity tranche (most risky).

The rating of CDOs are NOT the same as the rating of corporate bonds. CDOs earn a higher return (up to 2% p.a. more) than corporate bonds, due to the higher risk.

If you buy a structured product that is invested in the CDOs, you may not get the full extent of the higher return (for the higher risk), due to the expenses of the structured product.

Two large funds managed by Bear Stearns have made significant investment in CDOs which were rated AA or AAA. They have recently marked down the value of these highly rated CDOs significantly. The investor in their funds have lost most or all of their money. (This is a worst case scenario).

Lessons:

Avoid investing in CDOs, either directly or through structured products, unless you are familiar with this type of product, and you get a return that commensurate with the risk.