STRUCTURED PRODUCTS: Core fixed income is dying — long live CDOs, CBOs, CMOs, swaps, futures ...

As for pension plan interest, Mr. Nipp said pension plans are still in the early innings in showing interest in bond products that do use these tools. "There are some plans that are very comfortable with using those tools, there are some that aren't, and then there's every one in between," he said.

The $13.5 billion Alaska Retirement Management Board, Juneau, recently announced it would seek "higher-alpha" strategies for its $3 billion fixed-income portfolio.

Active fixed-income managers such as JPMorgan Investment Management, New York; INVESCO, Atlanta; Ryan ALM Inc., New York; and UBS Global Asset Management, Chicago, have launched or are planning to launch innovative structured fixed-income products for pension plans that are seeking stronger returns from their bond portfolios.

Karen McQuiston, senior vice president in the long-duration bond team at JPMorgan, said low returns in nearly all asset classes are leading money managers to offer innovative strategies. "This is happening in all areas, not just fixed income," she said. "Managers and clients are evolving together. Managers have been taking small steps in the structured product area until clients were ready to implement them."

Structured fixed-income comprises "any fixed-income product that uses multiple strategies such as leverage or derivatives, that enables the investor to do things that he or she could not have done simply by investing in the underlying security," said Keith Styrcula, president of the Structured Products Association, New York,

One strategy that has piqued the interest of institutional investors is carry trades, noted Dan Fuss, vice president and high-yield portfolio manager at Loomis, Sayles & Co., Boston. A carry trade is an arbitrage play in which an investor will borrow assets at low, short-term rates and invest in longer term, higher yielding securities. Mr. Fuss said that such trades have also pumped liquidity into the high-yield and emerging market debt markets, bringing yields down.

Also, collateralized default swaps have allowed managers to create long-short bond funds that are less costly than a long-short fund that uses traditional shorts.

The High-Yield Long-Short strategy from Barclays Global Investors, San Francisco, takes positions on investment-grade and high-yield bonds and allocates 10% of the portfolio to structured credits such as synthetic securities or tranches of collateralized debt obligations, as well as buying and selling credit protection via credit default swaps. The fund, launched in 2004, was one of the first of its kind for pension funds and other institutional investors, and it has been well-received. The fund has a cap of $1 billion, said Lance Berg, spokesman, although he declined to say whether that cap has been reached.

The advent of the credit default swap market allowed fixed-income managers to launch structured products that offer credit protection in the often high-risk world of junk bonds. At the beginning of 2004, Dow Jones & Co. New York, created the CDX, the first index tracking the credit default swap market. The index tracks the prices of contracts on 125 issues.

The CDS market "allows investors to express opinions on credit risk," said Eric Gould, portfolio manager of structured products at GE Asset Management, Stamford, Conn. "Another area of growth in structured product derivatives is the ABX and CMBX, which allows investors to buy or sell different credit profiles such as triple A through triple B of home equity and commercial mortgage backed securities in a more liquid structure."

According to the 2005 Fixed Income Survey by Greenwich Associates, Greenwich, Conn., credit default swaps represented the largest growing area in terms of trading activity by fixed-income dealers. CDS trading activity grew 100% between June 30, 2004, and June 30, 2005.

The ABX and CMBX indexes — the credit default swap indexes for asset-backed securities and commercial mortgage-backed securities, respectively — have helped boost the market's interest in structured fixed-income securities, Mr. Gould said. Dow Jones launched both indexes in January.

GEAM has selectively purchased single-name credit default swaps — it manages mostly ABS and CMBS that carry ratings from triple A to double B, Mr. Gould said. "We have selectively purchased real estate CDOs in the past and will continue to evaluate deals for future investment," he said. GEAM manages about $189 billion in assets, of which approximately $51 billion is from General Electric Co.'s defined benefit pension plan.

Structured fixed-income products are also being used as liability-driven investment tools. JPMorgan Investment Management, INVESCO, UBS Global Asset Management, Ryan ALM and Putnam Investments, Boston, are all either launching or incubating products that gain nominal exposure to a basket of fixed-income securities that match a pension plan client's liabilities, then port the alpha to another portfolio to gain returns in excess of those liabilities (Pensions & Investments, Nov. 28).

Money management firms and investment banks are also offering or are planning to offer swap overlay strategies to synthetically increase the duration of their pension clients' liabilities. Firms such as Merrill Lynch & Co., New York, JP Morgan, UBS, BGI and Northern Trust are all either planning to or are already offering such strategies. In such a strategy, a bond manager is able to swap the coupons of the bonds it holds through a dealer for a basket of coupons that have durations that more closely match the duration of its pension client's liabilities.

According to research conducted by Merrill Lynch & Co., New York, a pension plan that allocates 70% of its assets to equities and 30% to debt and then adds an interest rate swap overlay strategy would have improved its asset-to-liability ratio in every rolling 10-year period since 1975.

While a few U.S. pension plans — including International Paper, Norwalk, Conn. (P&I, Aug. 8) — are examining asset-liability management strategies, most are waiting to see the final version of a pension reform bill and whether the Financial Accounting Standards Boards will amend its Rule 87 to eliminate the practice of actuarial smoothing. Currently, Rule 87, which pertains to pension accounting, allows corporations to shift a portion of the capital gains and losses in its pension fund from one year to the next. Losing the ability to do that could make year-over-year liabilities on a balance sheet much more volatile, encouraging plans to examine asset-liability matching strategies to avoid such volatility.

Additionally, collateralized products have evolved to offer more complex structures. While interest in them from pension plans has remained light, CDO managers said they are encouraged that interest could pick up.

Kevin Petrovick, managing director and head of the global CDO group at INVESCO, said some of the larger pension plans are investing in the equity tranche of a CDO as part of their alternative investment portfolio, but investments in CDOs have been slow. He declined to name any pension plans.

"I think it's the education factor," Mr. Petrovick said. "A lot of them are not going to study a new asset class unless they are asked to. It takes a long time to mainstream a new asset class."

According to research conducted by JPMorgan Chase & Co., New York, global CDO volume reached $500 billion in 2005, up from $350 billion in 2003. Annual volume in the CDO market never exceeded $4 billion until 1996.

Leon Wagner, chairman of Goldentree Asset Management LLC, New York, which recently redeemed a $300 million CDO that it launched in 2000, said pension reform could spur greater interest in CDOs on the part of pension plans. He referred to the plan asset regulation set by the Department of Labor, which says that if a limited partnership fund such as a CDO or a hedge fund has more than 25% of its assets from pension plans, the manager of the fund must be registered as a fiduciary. Currently, Congress, as part of a pension reform package, is debating whether to raise that ceiling to 50%, which would create more capacity.

Matt Natcharian, director of the structured credit team at Babson Capital Management LLC, Boston, which manages about $4.5 billion in CDOs, said innovations in the product could also make it more attractive for pension funds.

"The biggest innovations in structure that we've been seeing is combining cash with synthetic assets. Credit default swaps on a corporate or asset-backed security has become popular. People are coming up with novel approaches for securitizing those assets." In a credit default swap, a bond holder can, for a premium, buy default protection from a counterparty.