What is a CDO?
• A CDO, or collateralized debt obligation, is a type of structured asset-backed security that possesses multiple Tranches, are issued by special purpose organizations and packaged with debt obligations including loans and bonds.
• CDOs will vary in formation and the underlying assets that make up the product; however, the basic principle will remain the same—a CDO is an asset-backed security created by a corporate entity to hold assets as collateral or to sell packages of debt and cash flows to investors.
• Each tranche of a CDO offers a varying level of risk and return to meet fluctuating investor demands. The value of a CDO is derived from the portfolio of underlying fixed-income assets; the tranches are divided into different classes based on a risk assessment, whereby “senior” tranches are regarded as the safest securities. This division is necessary because interest and principal payments are delivered in order of seniority. As a result, a junior tranche, due to the increased risk, will offer higher coupon payments or lower prices to entice investors and offset the increased exposure to default risk.
• A CDO is a fairly complex and unique investment product. To simplify the explanation, think of a CDO as a promise to distribute cash flows to investors in a predetermined sequence, based on how much money the CDO collects from its pool of fixed income assets. If the cash collected by the CDO is not enough to pay to all of its investors, those in the lower tranches will suffer losses first.
How is a CDO Created?
• A CDO is structured when a special purpose organization acquires a portfolio of assets, such as commercial real estate bonds, mortgage-backed securities and corporate loans. The SPE, once packaged, will the issue bonds to investors in exchange for cash.
• The cash is then used to purchase the portfolio of investments or debt. The bonds, when issued, are organized by different risk factors (tranches). As stated before, senior tranches are paid from the cash flows of the underlying securities before junior and equity securities. If the CDO loses money, losses are first assumed by the equity securities, then by the junior tranches and lastly by the senior tranches.
• The return and associated risk of the CDO depends on how the tranches are formulated and the performance of the underlying assets. A CDO enables the creator of the bundle to pass credit risk to other investors (institutions or individuals); as a result of this basic premise, it is crucial to understand how the particular CDO is calculated.
• A CDO is typically created by an investment bank; the investment security requires the presence of an underwriter and an asset manager before the bundle can be sold to other institutions or individual investors.