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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A synthetic callable bond is a security that has similar risk/return characteristics to a directly issued corporate callable bond but has better relative value. Most investment grade corporate issuers prefer bullet funding and have a weak bid for the call option imbedded in callable securities. Therefore, callable securities tend to be priced expensively. A synthetic callable bond investor owns a trust certificate that evidences beneficial interest in (a) a non-callable bond and (b) a written covered call option. The certificate offers a higher yield than a callable bond sold directly by the corporate issuer because of the relative cheapness of non-callable bonds to callable bonds.
Advantages
Synthetic callable bonds have several advantages over directly issued callable bonds, including:
• They often trade at a higher yield for comparable credit/interest rate risk.
• They offer flexible investment terms. The investor can set the call price, call frequency, the coupon and maturity to better meet their risk and yield requirements.
• The much wider selection of credits increases the investor's ability to diversify. The majority of investment grade corporate issuers do not issue callable bonds. Callable bond investors can diversify into those issuers that only have non-callable bonds.
■ An Example
Corporation XYZ, an "A" rated issuer, funds itself by selling 10 year non callable bonds. The company swaps the fixed rate to a floating rate of LIBOR+20 bps. XYZ will issue callable bonds (generally "non-call two years; callable every six months thereafter") if a dealer or investor inquires, but has a funding target below LIBOR for this structure (XYZ swaps the callable issue to a floating funding rate) because XYZ has a preference for bullet funding.
Investors that want the higher yield that callables offer do not buy callable bonds issued by XYZ since none are outstanding. The synthetic callable bond fills this void. A grantor trust purchases an XYZ 10-year non-callable bond (which, as noted is 25 bps per annum cheap to a prospective XYZ callable bond) and sells a call option on this bond to Merrill Lynch or another investor.
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A synthetic zero coupon bond is a security that has similar risk/return characteristics to a directly issued corporate zero coupon bond but has better relative value. Stripped coupon securities exist to bridge the gap between investor and issuer preferences. Most issuers do not sell zero coupon bonds for one of three reasons: (a) because of the proportionately large face amount required to achieve a fixed funding objective; (b) because in positive yield curve environments many issuers pay a higher interest rate on zero coupon bonds; (c) because the accreting nature of zero coupon bonds increases a company's leverage ratios unless the company retires debt each year.
The most basic structure is a synthetic zero coupon bond maturing on a fixed date. A special purpose vehicle is established to purchase a coupon bearing corporate bond and issue multiple classes of certificates each representing a single coupon payment or the final principal payment. An investor can purchase the synthetic zeros that fit their specific maturity needs. Absent any provision to the contrary, the entire principal claim would accrue to the benefit of the principal holder in the event the underlying bond is redeemed or is in default and is accelerated. Therefore, synthetic zero coupon bonds provide for allocation of any proceeds upon redemption or acceleration to each class based upon accretion schedules using the yield to maturity of each class on the issue date.
Applications
Investors purchase synthetic zero coupon bonds for several reasons, including:
• to increase duration and gain convexity;
• to obtain higher yields versus directly-issued zero coupon bonds; and
• to meet custom tenor and coupon targets. Synthetic zero coupon bonds are issued by a special purpose vehicle specifically designed to mimic the structural flexibility of medium term notes. The investor can thus set duration, convexity, call features, and maturity.
■ Example
An insurance company needs $100 million of 11.4-year duration assets to realign its portfolio with its benchmark index. Traditionally, this would be accomplished by buying $100 million 30 year corporate bonds, which in this example have a duration of 11.4 years and yield T+100 bps. Alternatively, the insurance company can purchase $38 million of a deferred coupon trust certificate that has a duration of 30.1 years and yields US T30 + 125 bps. The deferred coupon investment has a 0% coupon for years one through 20; at the end of year 20, the investor takes delivery of a 100-year coupon bond. On a dollar-weighted basis, $38 million of the trust certificate has the same duration as $100 million of 30-year coupon bonds and almost two times the convexity (for a 62% smaller investment amount). The insurance company also gets a return on cash of an additional 25 basis points versus current coupon 100-year bonds.
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