Collateralized debt obligation

A cash flow collateralized debt obligation, or cash flow CDO, is a structured finance product that typically securitizes a diversified pool of debt assets. These assets, corporate loans for instance, are split into different classes of bonds (known as tranches) that pay investors from the cash flows they generate.

Cash flow CDOs offer investors access to a diversified and actively managed portfolio of credit risks in a single investment that provides enhanced returns that correspond to each investor’s appetite for risk. Investors in CDO senior and mezzanine bonds can earn high returns relative to similarly rated asset-backed securities. CDO equity investors can earn leveraged returns.

Cash flow CDOs offer asset managers and issuing institutions a range of benefits, depending on the structure and motivation of each transaction. Asset managers can increase assets under management while locking in committed funds and achieving some protection from market value volatility. Issuing institutions can sell off portfolio credit risk, reduce regulatory capital requirements and lower funding costs.

Cash flow CDOs should be distinguished from market value CDOs, which are not discussed here. Whereas market value CDOs are managed to pay off liabilities through the trading and sale of collateral, cash flow CDOs are managed to pay off liabilities from the interest and principal payments of collateral. This means that unlike market value CDOs, cash flow CDOs focus primarily on managing the credit quality of the underlying portfolio rather than the volatility of its market value.

Collateral asset classes

Subject to investment guidelines set by each individual CDO the underlying assets may be static or revolving and may consist of any variety and configuration of:

corporate bonds;
bank loans;
emerging-market sovereign debt;
project finance debt;
asset-backed securities (ABS) and other structured finance securities (such as CMBS, RMBS and HEL); or
credit derivatives

The underlying collateral may be static or may be managed by an asset manager who generally has demonstrated experience in managing the asset classes mandated by the transaction.

The asset manager

The asset manager often has broad discretion to purchase and/or trade collateral and plays a key role in each CDO transaction.

Bond classes and the priority of payments

The securities issued by the CDO are split into rated and unrated classes of bonds and equity, where the rating of each bond class is determined by its position in the priority of payments and other rating criteria. Payments of interest and principal to the various bond classes (or liabilities) issued by a CDO are generally made sequentially, such that payment is first made to the most senior class and then to other classes, in the order of their subordination. These payments are made solely from the cash flows received from the underlying assets (including hedges).

The senior bonds are usually rated AAA to A and have first claim on cash flows. The mezzanine and subordinated bonds are usually rated BBB to B and have a subordinate claim on cash flows. The equity tranche, which occupies a first-loss position, is generally unrated and receives all or most of the residual interest proceeds of the collateral. The CDO equity represents a leveraged investment in the collateral; it has both a higher expected return (assuming of course that the expected return of the underlying return is positive, ie that expected losses are lower than coupon payments) and a higher volatility of return than the underlying assets.

The high risk of the equity tranche has led to allegations of mis-selling[1], with market commentators referring to this asset class as 'Toxic Waste' [2].

Motivation type: arbitrage, balance sheet

Cash flow CDOs are usually classified as either arbitrage or balance sheet transactions. Arbitrage transactions attempt to capture for equity investors the spread between the relatively high yielding assets and the lower yielding liabilities represented by the rated bonds. Balance sheet transactions, by contrast, are primarily motivated by the issuing institutions’ desire to remove loans and other assets from their balance sheets, to reduce their regulatory capital requirements and improve their return on risk capital.

Synthetic

Some balance sheet transactions use credit derivatives to transfer the credit risk of assets from balance sheets to CDOs without the sale or transfer of the assets themselves. These structures, which may be non-funded or partially funded, are called "synthetic CDOs."

While "cash CDOs" (cash flow CDOs) involve a pool of loan contracts, corporate bonds, asset-backed securities or mortgage-backed securities, synthetic CDOs are formed from a large pool (usually more than 100 names) of CDSs. Synthetic CDOs have become very popular in recent years, especially in Europe where over 90% of deals are synthetic. In the U.S., synthetic deals account for one third of all arbitrage CDOs. Synthetic CDOs allow more flexible structure than cash CDOs, thanks to the unique characteristics of CDS.

CDOs squared

More complex CDO structured have developed where each underlying credit risk is itself another CDO tranche or asset-backed security. These CDOs are typically referred to as CDOs-squared and may contain many references to the same underlying credit risk so are very difficult to price and risk manage/hedge.

Typically a CDO squared structure will pay a higher yield for a given rating to reflect the possibly much greater risk. Since not many banks/wall street firms have the technology to price these structures, a CDO2 deal may pay the structurer a very high margin (hidden, though, as only the offer price is shown to the client).

Market growth

First issued in the late 1980s, CDOs emerged a decade later as the fastest growing sector of the asset-backed securities market. This growth reflects the increasing appeal of CDOs for a growing number of asset managers and investors, which now include insurance companies, mutual fund companies, unit trusts, investment trusts, commercial banks, investment banks, pension fund managers, private banking organizations and structured investment vehicles.