Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) with value and payments derived from a portfolio of fixed-income underlying assets.

CDO Structure

Collateralized loan obligations (CLOs) are CDOs backed primarily by leveraged bank loans. Collateralized bond obligations (CBOs) are CDOs backed primarily by leveraged fixed-income securities.

CDOs are assigned different risk classes, or tranches.

• A senior tranche: between 70% and 80% of the deal and receives a floating-rate payment
• Subordinated or mezzanine tranches: receive a fixed coupon rate
• Equity tranche: provides equity protection to other tranches. It receives any remaining interest that is received from the collateral but not paid to the senior and mezzanine tranches.

Problem: The majority of investors are paid a floating rate, whereas the underlying pool bonds pay a fixed rate. If rates rise, the collateral manager can get burned. This is because the manager could find itself having to pay out an increasingly higher rate to tranche holders while its source of funds - interest on the underlying bonds - is fixed.

Solution: The manager must protect against rising rates. Entering a swap as the fixed payer (variable receiver) solves the problem, as this position provides positive cash flow when interest rates rise.

Example

Consider the following CDO transaction:

• The CDO is a $100 million structure.
• The collateral consists of bonds that all mature in five years. The coupon rate of these bonds is the five-year T-bond rate plus 500 basis points.
• The senior tranche is 75% of the deal. It pays a floating rate of LIBOR + 50 basis points.
• There is only one mezzanine tranche of $10 million with a coupon rate of the five-year T-bond rate + 400 basis points.
• The asset manager enters into a swap in which it pays a fixed rate equal to the five-year T-bond rate + 150 basis points and receives LIBOR. The notional amount of the swap is $75 million.
• Assume that there is no default or asset management fee. All payments are made annually each year for simplicity.

Analysis

The equity tranche is $100 - $100 x 0.75 - 10 = $15 million.

Each year:

• The collateral will pay interest of $100 x (T-rate + 5%) million to the CDO.
• The CDO pays $75 x (T-rate + 1.5%) to the counterparty of the swap and receives $75 x LIBOR.
• Interest to senior tranche: $75 x (LIBOR + 0.5%)
• Interest to mezzanine tranche: $10 x (T-rate + 4%)

Netting the interest payments paid and received:

$100 x (T-rate + 5%) - $75 x (T-rate + 1.5%) + $75 x LIBOR - $75 x (LIBOR + 0.5%) - $10 x (T-rate + 4%) = ($15 x T-rate + $3.1) million

If the five-year T-rate at the time the CDO is issued is 5%, the amount available each year for the equity tranche is $15 x 0.05 + 3.1 = $3.85 million.

Cash CDOs

Cash CDOs involve a portfolio of cash assets, such as loans, corporate bonds, asset-backed securities or mortgage-backed securities. Ownership of the assets is transferred to the legal entity (a SPV) issuing the CDOs' tranches. The risk of loss on the assets is divided among tranches in reverse order of seniority.

Motivation - Arbitrage vs. Balance Sheet

• 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. The majority of CDOs are arbitrage-motivated.

• 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. A bank may wish to offload credit risk in order to reduce its balance sheet's credit risk.