Every investor knows that diversifying your portfolio is a good way to minimize risk. Diversification is also meaningful for big institutional investors who purchase collateralized debt obligations, known as CDOs. For these investors, Moody's developed the diversity score as a way to gauge the relative risk of a particular CDO. More diversified CDOs have higher diversification scores, which means they pose less risk to the investor.
A CDO is collection of debt instruments. One type of CDO is the collateralized loan obligation. A CLO is an investment instrument made up of a pool of business loans, such as corporate bonds. Anther common type of CDO is the CMO, or collateralized mortgage obligation, in which the investment pool consists of mortgage securities. Investment brokers categorize CDOs as asset-backed securities because the underlying debts are considered assets. Investors in a CDO get paid as those underlying debts are serviced. Problems arise if the default rate on those debts is high. Moody's developed the diversity scores because investors needed a metric to identify the risk of a particular CDO.
The diversity score is based on the idea that businesses in a particular field tend to respond to the same market influences. References to the tech boom, the tech bust or the housing bust indicate that the industries in those areas are responding the same way. The likelihood that businesses share the same risk of default is called the default correlation. A CLO with a high diversity score is theoretically shielded from such ups and downs because not everything in the CLO is subject to the same market conditions.
Doing the Math
Moody's uses a proprietary technique to calculate the diversity index. This technique involves creating a synthetic portfolio of identical assets that mirrors the actual portfolio. Assets in the same industry are considered identical. An independent default risk is assigned to each asset in the portfolio. The diversity score is the number of assets. Moody's can calculate a diversity score for each tranche -- or particular portion -- of the synthetic portfolio.
Moody’s diversity score is an imperfect technique for measuring risk because it does not consider how industries within a portfolio may be linked. For example, a CLO involving loans to petroleum producers and loans to trucker groups would be considered diversified even though the price of gas has an immediate impact on trucking. Some analysts criticize the diversity score because they believe that it over-estimates default correlation and default probability and that it underestimates recovery rates once loans have defaulted.
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