Recently, managed CDOs - especially those backed by US high yield bonds - have come under increasingly harsh criticism. The charges against CDOs are motivated by a perception of low realized equity returns and numerous rating downgrades. In this report, we argue that:

*CDO equity performance depends significantly on the excess returns of the underlying asset class, and

*as part of a risk-controlled investment strategy, CDO equity outperforms a direct investment in the underlying asset class.

CDOs have sometimes been described as a distinct "asset class," on par with equities, fixed income, and commodities. We believe that this characterization of CDOs is misleading. Instead, CDOs should be viewed as an investment strategy in the selected underlying asset class. For example, an investor seeking to allocate funds to high yield bonds can choose from several possible investment strategies: a mandate benchmarked to an index, an absolute total return strategy, such as a hedge fund, or a CDO. Each strategy provides investors with a distinct exposure to the returns on the underlying assets.

An allocation to a risky asset class by an investor typically expresses the view that the selected assets will generate returns above the risk free rate. Risky investments can be broken down into two components: a stable value portion that returns the risk free rate and a risky component that pays the excess return. Whereas a direct investment in the asset class commingles exposures to both return components - the stable value and the excess return - a position in CDO equity is a "pure play" investment in the excess return portion.

Investors who made allocations to high yield bond CDO equity over the past four years generally expected positive excess returns on high yield bonds. Instead, the 1998-2001 period saw some of the worst performance in the history of high yield bonds, caused by a combination of widening spreads and high default rates.

Realized returns on CDO equity are not easily available, because CDO managers and underwriters do not, as a rule, publish performance statistics. We use the realized Goldman Sachs high yield bond CDO equity IRRs through December 2001 as a measure of return performance. Realized IRRs are computed using actual equity distributions and the December 2001 month-end valuation as the terminal value.

Exhibit 1 reports the returns on Goldman Sachs-led CDO equity, the total and excess (over the Merrill Lynch Treasury Index) returns on the Merrill Lynch Single-B Index, and the return on the explicit excess return/stable value strategy. The CDO equity return is a weighted average of individual IRRs through December 2001 on all Goldman Sachs high yield bond CDO equity issued during the corresponding year. In isolation, CDO equity returns appear low. However, the excess return on high yield bonds was negative during this period. Since equity is a "pure play" investment in the excess return on high yield bonds, its disappointing performance can be explained by the negative excess returns on the underlying single-B bonds.

To make a meaningful comparison between high yield bond CDO equity performance and a direct investment in the underlying high yield bonds, we add back the stable value return component to equity returns. The last column of Exhibit 1 shows the returns on the explicit excess return/stable value investment strategy. This strategy invests 10% in CDO equity and 90% in the Merrill Lynch Treasury Index. The CDO equity portion represents the excess return component of single-B high yield bonds, while the Treasury index provides the stable value return. The explicit excess return/stable value strategy outperforms the direct high yield bond investment in all four years. The reason for the superior performance of the explicit excess return/stable value strategy is the 10% limit on capital at risk provided by the CDO equity position.

Unlike high yield bonds, syndicated leveraged loans have generated positive excess returns in three of the last four years. Exhibit 2 shows the weighted average IRRs of Goldman Sachs-led leveraged loan CDO equity classes, the total and excess (over a one-month Libor roll) return on the LPC/Goldman Sachs Index, and the performance of the explicit return/stable value strategy. Over the 1998-2000 period, leveraged loans generated positive total and excess returns. In 2001, the excess return was slightly negative. The explicit excess return/stable value strategy of investing 8% in leveraged loan CDO equity and 92% in one-month Libor slightly outperformed the LPC/Goldman Sachs Leveraged Loan Index in 1998, 2000, and 2001. In 1999, the excess return/stable value strategy slightly underperformed the index.

As part of a excess return/stable value strategy, leveraged loan CDO equity performed roughly the same as a direct investment in leveraged loans. This result, taken together with the high yield bond CDO equity results, demonstrates the advantage of the explicit excess return/stable value strategy over a direct investment in the underlying asset class. When the underlying asset class generates positive excess returns, the performance of the excess return/stable value strategy is similar to that of a direct investment. However, when the underlying assets produce negative excess returns, as was the case with high yield bonds in the 1998-2001 period, the limit on losses provided by the excess return/stable value approach can result in outperformance relative to the underlying assets.

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