Collateralized Debt Obligations (CDOs) are special purpose vehicles designed to tranche the cash flows generated by an underlying collateral pool. CDOs is the umbrella term for two main products, Collateralized Bond Obligations (CBOs) and Collateralized Loan Obligations (CLOs). The underlying collateral pool for CBOs generally consists of high yielding bonds (sometimes emerging market issues); the underlying collateral pool for CLOs consists of leveraged bank loans. The collateral pool is selected and managed by an experienced asset manager. The portfolio is financed through the issuance of multiple tranched classes of securities, much like an asset-backed security. A typical CDO will have a high rated investment grade floating rate senior secured liability, a lower rated investment grade subordinated tranche, and an unrated junior subordinated note.
Benefits and Advantages
CDOs segment the investment risk associated with the corresponding underlying assets between different classes of investors. In particular, the unrated junior subordinated tranche ("the Equity") represents a leveraged non-recourse investment in high yield assets. Projected returns for the Equity can range from 15% to 50% depending on the capital structure of the SPV.
As the investment in the Equity is non-recourse, its holder is not subject to capital calls from the CDO vehicle. This type of financing is not currently available through any other type of market instrument. Stated alternatively, the Equity holder is effectively long a put option on the portfolio of assets and long a leveraged position in the portfolio of assets. Thus, the Equity can be viewed as owning a long-term synthetic call option on the portfolio
Examples•
A total return investor that seeks low-rated securities has several options. On a financed basis, these include: the use of cash market leverage (margin loan); a total return swap on a basket of securities or loans; and the purchase of the Equity of a CDO. The Equity benefits from term leverage, automatic reinvestment, simple booking and professional management.
• An insurance company that owns a portfolio of high yield and emerging market bonds can sponsor a CDO and deposit those assets into the vehicle. The manager would retain all or part of the Equity, and could invest the proceeds from the assets sold into new high yield issues, or could opt for lower risk assets for this portion of his portfolio.
• An insurance company that has an objective of improving return on NAIC capital owns "AA" rated corporate bonds that have been asset swapped to LIBOR flat. The insurance company sells the bonds, terminates the related interest rate swaps, and then buys a senior tranche of a Merrill Lynch CDO that is rated "AA". This CDO senior tranche yields LIBOR + 35 bps, for a pickup of +35 bps using the same amount of NAIC capital.
• A bank that owns a portfolio of loans has the objective of improving return on equity capital. The loan portfolio has a regulatory capital requirement of 8%. The bank buys default swap protection on the portfolio of loans from an SPV and, subject of the necessary regulatory approvals, treats the loan portfolio as fully hedged and reduces the capital charge to zero. The SPV issues CBO tranches of debt to cover the default swap protection which are distributed by Merrill Lynch. The bank purchases the most junior tranche (equity tranche), and sets aside 100% regulatory capital against this. To the extent that the size of the equity tranche is smaller than 8% of the loan portfolio, the regulatory capital requirement has been reduced.
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