Collateralized Debt
Obligations
Fabozzi -- Chapter 15
Introduction to CDOs
 A Collateralized Debt Obligation (CDO) - security backed by
a diversified pool of one or more of the following:
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Domestic investment grade and high yield bonds
Domestic bank loans
Emerging market bonds
Special situation loans & distressed debt
Foreign bank loans
Asset-backed securities
Residential & commercial mortgage-backed securities
 Two Types of CDO’s
 Collateralized Bond Obligation
 Consists of bond-type instruments
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Collateralized Loan Obligation
 Consists of Bank Loans
Structure of a CDO
 Collateral manager
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Responsible for managing portfolio of debt obligations
The debt obligations collectively are called “collateral”
Individual issues within this are called “collateral assets”
 Tranches
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Debt obligations issued by the collateral manager including:
 Senior tranches
 Mezzanine tranches (Not always)
 Subordinate / Equity tranches
 Tranche Credit Rating
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Sought for all except subordinate tranches
Senior is usually A rating minimum
Mezzanine is usually B rating minimum
 Maintaining Credit Rating
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Restrictions on collateral manager at time of issuance
Structure of a CDO - continued
 Ability of Collateral Manager to make interest
payments depends upon performance of collateral:
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Coupon interest payments from collateral assets
Maturing of collateral assets
Sale of collateral assets
 Typical Set Up
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One or more tranches pays a floating rate of interest*
Interest rate swaps are used to hedge this risk
 Collateral Manager pays fixed rate and receives floating rate in
swap
 Rating agencies require this to manage the mismatch of cash
flows
Arbitrage vs. Balance Sheet
Transactions
 Type depends upon motivation of the deal sponsor
 Arbitrage Transaction:
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Objective is to earn a spread between yield on collateral and the
payments made to the tranches
 Typically Investment Banks trying make a profit
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Balance Sheet transaction
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Objective is to remove debt instruments (loans) from it’s balance
sheet
 Typically commercial banks seeking to reduce capital requirements
Arbitrage Transactions (Focus of this chapter)
 How to determine if it’s feasible to create an arbitrage CDO
 Critical factor is if it can create a competitive return for the
subordinate / equity tranche
 Example on Pages 351-352 in text
 Analysis is done to measure:
 Interest payments from the collateral vs.
 Interest that must be paid to Senior and Mezzanine tranches
 Remaining interest payments from collateral will be compared
with the size of the subordinate tranche to determine if the return
is high enough to support an arbitrage
 Book example on page 352 shows a 25% return on a $10 Million
subordinate tranche
Arbitrage Transactions - continued
 Early Termination
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Can occur if there is a default or events such as:
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Failure to comply with covenants
Failure to meet payments to senior tranches
Bankruptcy of issuing entity of CDO
Departure of collateral management team
 Arbitrage Transactions are further broken into 2 types:
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Cash Flow transactions
Market Value transactions
Arbitrage Transactions - continued
 Cash Flow transactions
Collateral manager is not free to buy & sell bonds
 Restricted by credit risk considerations from rating agencies
Quality tests and Coverage tests
 Quality tests measure the diversity of the assets and include:
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Minimum asset diversity score
Minimum weighted average rating
Maturity restrictions
Limits on geographic exposure or emerging markets
Coverage tests include:
 Par Value Tests – see page 355*
 Interest coverage ratio tests
Arbitrage Transactions - continued
 Market Value transactions
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Unlike Cash Flow transactions
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Collateral manager is expected to trade to improve market value
Also tries to minimize volatility
More rare than cash flow transactions
Used when cash flow is less predictable
Rating Market Value transactions:
 Agencies look at collateral’s ability to generate sufficient cash
flow
 They look at collateral defaults and recovery rates*
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Collateral manager’s focus:
 Control defaults and recoveries
Arbitrage Transactions - continued
 Overcollateralization Tests:
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Based on Market Value of collateral – not par value
Advance Rates are determined based on asset types
 See example on Pages 357-358*
 Example using Moody’s Rating agency method
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Advance rates are multiplied by market values
 This determines an adjusted market value
 Adjusted market values based on:
 the asset type X the Advance Rate
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Key to understanding the method:
 The lower the credit rating sought, the higher the advance rate
 Table of advance rates is determined for each credit rating
Synthetic CDOs
 In a synthetic CDO:
 The collateral itself still absorbs its typical economic risks
 But collateral assets are not actually owned by collateral manager
 Credit Default Swaps are required
 They transfer credit risk on specified assets to a third party
 Specified assets do not have to be owned but often are by one party
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A CDS can be used to transfer credit risk on a pool of loans
 This is done without transferring any of the loans themselves
 It’s like an insurance policy
 Buyer gets principal returned in case of a default or credit event
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Credit events must be clearly defined and may include:
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Bankruptcy
Failure to pay when due
Downgrading of an issue
Debt Repudiation
Debt restructuring