LOS f: Describe collateralized debt obligations (CDOs), including cash and synthetic CDOs.

The collateral usually has a mix of floating and fixed rate debt so interest rate swaps are used to manage the risk from cash flow mismatches. Interest rate swaps are often used by asset managers to control the interest rate risk imposed by this mismatch, Rating agencies usually mandate the use of swaps. In CDOs there is usually a senior tranche that receives a floating rate, mezzanine tranches that receive a fixed rate, and a subordinate or equity tranche that provides prepayment and credit protection to the other tranches.

Arbitrage CDOs are the majority of cash CDOs and are issued to profit on the spread between the return on the underlying assets and the return paid to investors. A bank or insurance company wishing to reduce their loan exposure on the balance sheet creates a balance sheet CDO. Cash CDOs have three phases in their lifetime. During the ramp up phase, the portfolio is created using financing from different tranches. During the reinvestment phase, cash flows from prepayments and default recoveries are reinvested, assuming coverage tests are satisfied. In the pay down phase, principal payments are made to junior and senior tranche holders and the CDO is wound down.

In a synthetic CDO, the ramp up period is shorter than the ramp up period for cash CDOs because no actual (cash) debt obligations are purchased. Instead, the synthetic CDO gains exposure and earns a return by selling a credit default swap. By selling a credit default swap, they pay the buyer a specific amount if a credit event occurs (e.g. bankruptcy) and in return receive a swap premium. In essence, the CDO has credit exposure and earns a return just as if they had bought the underlying bond. The senior portion doesn’t require funding.

A CDO is an asset-backed security (ABS) that is collateralized by a pool of debt obligations comprising below investment grade corporate bonds, corporate loans advanced by commercial banks, and bond issues in emerging markets. Investment grade bonds are not typically an underlying asset in CDOs.