Collateral Debt Obligations | CFA Level I Fixed Income
CDOs are structured securities backed by a pool of debt obligations, like mortgages, auto loans, or credit card loans. When we pool multiple ABS together as collateral, we create CDOs.
Types of Collateral Debt Obligations
- Structured finance CDOs – CDOs made up of structured finance securities.
- Collateral bond obligations – CDOs backed by corporate and emerging market bonds.
- Collateralised loan obligations – CDOs backed by leveraged bank loans.
- Synthetic CDOs – CDOs backed by a portfolio of credit default swaps for other structured securities.
To create a CDO, a special purpose vehicle is established, ensuring the assets are bankruptcy-remote from their original owners. The funds to purchase the collateral assets for a CDO are obtained from the issuance of debt obligations.
CDO Structure and Returns
CDOs typically issue three classes of bonds:
- Senior bonds – Highest credit ratings
- Mezzanine bonds – Lower ratings than senior bonds
- Subordinated (equity) bonds – Sometimes called the equity or residual tranche
A typical CDO structure issues a floating-rate senior tranche and a smaller mezzanine tranche that pays a fixed rate of interest. The returns to a CDO can come from various sources, as CDOs have a collateral manager who executes trades in the securities in the collateral pool to earn a rate of return higher than the aggregate cost of the bond classes.
EXAMPLE
If the aggregate cost of the bond obligations is 4.7%, and the return of the CDO for the period is 6.2%, the 4.7% goes to pay the bond obligations to the senior and mezzanine bondholders, and the excess 1.5% goes to the equity tranche holders and the CDO manager. If the CDO managers take 0.7%, the balance 0.8% goes to an accrual account for the equity tranche. Note that this 0.8% is based on the total par value of the CDO. So the return to the tranche holders is actually 8%, as the equity tranche is only one-tenth of the total par value.
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