CDOs are a form of asset-backed securities where the underlying collateral is a diversified pool of debt instruments such as junk bonds, bank loans, or emerging market debt.
Collateralized Loan Obligations (CLOs): This is the case where the loan pool is entirely bank loans.
Collateralized Bond Obligations (CBOs): This is the case where the loan pool is entirely bond like instruments.
CDO Tranche Structure
- High Quality Senior Tranche: These bonds are typically floating rate and will be entitled to the majority of the cash flows generated by the asset pool.
- Lower Quality Junior Tranches: These bonds are typically fixed rate and will absorb some of the default risk.
- Equity Tranche: This tranche receives payments from the asset pool that are not paid to the senior and junior tranches.
In the case where the underlying assets are fixed rate, interest rate derivatives will need to be employed to manage obligations to the senior tranche.
CDO Life Cycle
- Start-up Phase: For a period of one to two months, CDO securities are sold to the investing public and the sale proceeds are used to purchase debt instruments for portfolio.
- Reinvestment Phase: A period of three to five years; the portfolio manager will reinvest prepayments from the asset portfolio.
- Pay-down Phase: principal is repaid to investors based on the sequence prescribed in the ABS indenture.
Cash Vs. Synthetic CDO
Cash CDO: The CDO actually holds the underlying securities.
Synthetic CDO: The CDO uses derivatives to obtain economic exposure to desired securities.
CDO sponsor motivation determines whether the objective category is arbitrage driven or balance sheet driven.
- Arbitrage Driven CDOs: The goal of these CDOs is to earn a positive spread between the cost of funds (the interest paid to CDO investors) to acquire the asset collateral and the return on the collateral. In other words, the CDO issuer seeks to generate a return from the assets that is greater than the rate paid to investors.
- Balance Sheet Driven CDOs: The goal of these CDOs is to allow banks to remove loan assets from their balance sheets in order to remove credit risk exposure.