Collateralized Debt Obligations

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Definition: Collateralized Debt Obligations


Quick Summary of Collateralized Debt Obligations


Collateralized debt obligations are securitized interests in pools of – generally non-mortgage – assets. Assets – called collateral – usually comprise loans or debt instruments.




What is the dictionary definition of Collateralized Debt Obligations?

Dictionary Definition


A Collateralized Debt Obligation or CDO is investment-grade security endorsed by a pool of loans, bonds and other assets. The structure of a CDO can be constructed of debt of any type-except mortgages. A collateralized debt obligation is generally cut up into slices, each slice of debt carrying a unique amount of risk associated with it. Each slice (also known as tranch) has a maturity period dissimilar to its peers in the same CDO. The greater the risk in a slice, the more paying potential of CDO.

CDOs are usually purchased by investors who want the associated benefits rendered by the specific debt but do not wish to buy the debt themselves.


Full Definition of Collateralized Debt Obligations


Collateralized debt obligations (CDO) are a form of asset-backed security (ABS).

Collateralized debt obligations are complex structured investment products that are collateralized by a group of assets (i.e. bonds, business loans, other collateralized debt obligations, etc.). The idea behind collateralized debt obligations is that you can create an investment-grade financial product and create liquidity by pooling assets together. Collateralized debt obligations pool assets which would be more illiquid and/or riskier on their own and therefore not as tradable. Collateralized debt obligations are sold in various tranches. Each tranche of a collateralized debt obligation offers a different risk level and depending on the type of collateralized debt obligations, a different maturity as well. Tranches of collateralized debt obligations with higher credit risk tend to be sold at higher prices than tranches with lower default risk. Once collateralized debt obligations are sold, the underwriter has no further responsibility in collecting on the debt. As a result, should a default occur, it becomes the responsibility of the holder of the collateralized debt obligations to collect. Misaligned interests between investors and underwriters of collateralized debt obligations can lead to lower standards when selecting eligible assets to be included within collateralized debt obligations. Collateralized debt obligations only including bonds are called collateralized bond obligations (CBO). Collateralized debt obligations only including commercial loans are called collateralized loan obligations (CLO). They are both types of collateralized debt obligations. Although collateralized debt obligations include bank loans, collateralized debt obligations do not typically include mortgages. Mortgages are pooled in asset-backed securities called collateralized mortgage obligations (CMO).

A CDO may be called a collateralized loan obligation (CLO) or collateralized bond obligation (CBO) if it holds only loans or bonds, respectively. Investors bear the credit risk of the collateral. Multiple tranches of securities are issued by the CDO, offering investors various maturity and credit risk characteristics. Tranches are categorized as senior, mezzanine, and subordinated/equity, according to their degree of credit risk. If there are defaults or the CDO’s collateral otherwise underperforms, scheduled payments to senior tranches take precedence over those of mezzanine tranches, and scheduled payments to mezzanine tranches take precedence over those to subordinated/equity tranches. Senior and mezzanine tranches are typically rated, with the former receiving ratings of A to AAA and the latter receiving ratings of B to BBB. The ratings reflect both the credit quality of underlying collateral as well as how much protection a given tranch is afforded by tranches that are subordinate to it.

A CDO has a sponsoring organization, which establishes a special purpose vehicle to hold collateral and issue securities. Sponsors can include banks, other financial institutions or investment managers, as described below. Expenses associated with running the special purpose vehicle are subtracted from cash flows to investors. Often, the sponsoring organization retains the most subordinate equity tranche of a CDO.

For someone who is new to CDOs, the instruments can seem difficult to understand. This is because there are actually a variety of different instruments that are all lumped together under the moniker “CDO.” Some of the different structures are detailed below.

One important distinction is that between static and managed deals. With the former, collateral is fixed through the life of the CDO. Investors can assess the various tranches of the CDO with full knowledge of what the collateral will be. The primary risk they face is credit risk. With a managed CDO, a portfolio manager is appointed to actively manage the collateral of the CDO. The life of a managed deal can be divided into three phases:

Ramp-up lasts about a year, during which the portfolio manager initially invests the proceeds from sales of the CDO’s securities.

The reinvestment or revolver period lasts five or more years. The manager actively manages the CDO’s collateral, reinvesting cash flows as well as buying and selling assets.

In the final period, collateral matures or is sold. Investors are paid off.

At the time they purchase the CDO’s securities, investors in a managed deal do not know what specific assets the CDO will invest in, and those assets will change over time. All investors know is the identity of the portfolio manager and the investment guidelines that he will work under. Accordingly, investors in managed CDOs face both credit risk as well as the risk of poor management. Investors have the added burden of paying portfolio management fees. Today, most CDOs are managed deals. In many cases, the portfolio manager is the sponsor.

CDOs can be structured as cash-flow or market-value deals. The former is analogous to a CMO. Cash flows from collateral are used to pay principal and interest to investors. If such cash flows prove inadequate, principal and interest are paid to tranches according to seniority. At any point in time, all immediate obligations to a given tranch are met before any payments are made to less senior tranches.

With a market value deal, principal and interest payments to investors come from both collateral cash flows as well as sales of collateral. Payments to tranches are not contingent on the adequacy of the collateral’s cash flows, but rather the adequacy of its market value. Should the market value of collateral drop below a certain level, payments are suspended to the equity tranche. If it falls even further, more senior tranches are impacted. An advantage of a market value CDO is the added flexibility they afford the portfolio manager. She is not constrained by a need to match the cash flows of collateral to those of the various tranches.

Another distinction is that between balance-sheet CDOs and arbitrage CDOs. These names correspond to respective motivations of the sponsoring organization. With a balance sheet deal, the sponsoring organization is a bank or other institution that holds—or anticipates acquiring—loans or debt that it wants to remove from its balance sheet. Similar to a traditional ABS, the CDO is a vehicle for it to do so. Arbitrage deals are motivated by the opportunity to add value by repackaging collateral into tranches. This is the same motivation for most CMOs. In finance, the law of one price suggests that the securities of a CDO should have the same market value as its underlying collateral. In practice, this is often not the case. Accordingly, a CDO can represent a theoretical arbitrage. In addition to balance-sheet and arbitrage CDOs, TruPS CDOs represent a third, smaller segment of the market.

Much of the “arbitrage” in an arbitrage CDO arises from a persistent market imperfection related to the somewhat arbitrary distinction between investment-grade and junk debt. Many institutional investors face limits on their ability to hold below-investment-grade debt. This can take the form of regulations, capital requirements, and investment restrictions imposed by management. Insurance companies, pension plans, banks and mutual funds can all face some sorts of limitations. As a result, junk often trades at spreads to investment-grade debt that are wider than might be explained purely by credit considerations. With a CDO, a portfolio of below-investment-grade debt can be repackaged into tranches, some of which receive investment-grade – and even AAA -ratings.

CDOs are mostly about repackaging and transferring credit risk. While it is possible to issue a CDO backed entirely by high-quality bonds, the structure is more relevant for collateral comprised partially or entirely of marginal obligations.

This leads us to another important distinction: that between cash and synthetic CDOs. So far, we have been discussing cash CDOs. These expose investors to credit risk by actually holding collateral that is subject to default. By comparison, a synthetic deal holds high quality or cash collateral that has little or no default risk. It exposes investors to credit risk by adding credit default swaps (CDSs) to the collateral. Synthetic CDOs can be static or managed. They can be balance-sheet or arbitrage deals.

Arbitrage synthetic deals are motivated by regulatory or practical considerations that might make a bank want to retain ownership of debt while achieving capital relief through CDSs. In this case, the sponsoring bank has a portfolio of obligations, called the reference portfolio. It retains that portfolio, but offloads its credit risk by transacting CDSs with the CDO.

For arbitrage synthetic deals, two advantages are

  • an abbreviated ramp-up period (for managed deals), and
  • the possibility that selling protection through CDSs can be less expensive than directly buying the underlying bonds. This is often true at the lower end of the credit spectrum.

The biggest advantage to (balance sheet or arbitrage) synthetic CDOs often is the fact that they don’t have to be fully funded. For a cash CDO to have credit exposure to USD 100MM of bonds, it must attract USD 100MM in investments so it can buy those bonds. With a synthetic deal, credit exposure to USD 1000MM in obligations might be supported by just USD 150MM in high-quality collateral. In such a partially-funded deal, the entire USD 1000MM reference portfolio is tranched, but only the lower-rated tranches are funded. In this example, the most senior USD 850MM tranch would be called a super senior tranch. It might be retained by the sponsor or sold off as a CDS. The funded piece might comprise USD 100MM of investment-grade tranches and USD 50MM of mezzanine and unrated tranches.

In arbitrage deals, partial funding offers higher capital relief than does full funding under the Basel capital requirements. For synthetic deals, it is generally less expensive to sell the super senior tranch as a CDS than it would be to fund that tranch.

Analyzing CDOs is difficult. Not only is there an entire portfolio of credits to analyze, in managed deals, an investor won’t know what collateral will be purchased. On top of this is the added complexity of the tranching, which must also be analyzed. Sophisticated portfolio credit risk models should be used. Needless to say, there is much potential for manipulation or abuse by sponsors. CDOs are appealing to investors because of the attractive yields they offer, but this market, more than most, is one of caveat emptor.

Synthetic CDO

It is a kind of collateralized debt obligation or CDO that is endorsed by credit derivatives. The list of credit derivatives may include forward contracts and options.

Collateralized Bond Obligation (CBO)

A Collateralized Bond Obligation or CBO is an investment-grade bond endorsed by a pool of junk bonds or high yield bonds. A CBO is considered investment grade for the presence of credit quality bonds despite junk bonds, not investment grade.

Collateralized Mortgage Obligation (CMO)

It is a variation of mortgage endorsed security that makes different pass-through rate pools with dissimilar maturities called tranches. Repayments from these tranches are employed to retire bonds in accordance with that bonds’ prospectus. CMOs are associated with low risk and thus offer lower returns. Some CMOs are endorsed by government securities.

Asset-Backed Commercial Paper

Asset-backed commercial paper is a type of investment that is characterized by short maturity times. The maturity time is generally between 90 and 180 days. The commercial paper is endorsed by tangible assets, including trade receivables. Asset-backed commercial paper is usually employed to meet financial needs in the short term.


Synonyms For Collateralized Debt Obligations


CDO

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Definition Sources


Definitions for Collateralized Debt Obligations are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 17th April, 2020 | 34 Views.