Collateralised Debt Obligation - CDO

A Collateralised Debt Obligation (“CDO”) is a security backed by a diversified pool of one or more classes of debt. 

A CDO is a structured debt instrument.  One of the simplest and most common forms of structured product in Australia is a mortgage-backed security (MBS).  A special purpose vehicle, usually a trustee, purchases mortgages from an originator (mortgage broker) and then issues MBSs. This is called a ‘pass-through’ structure as the mortgages are the only asset of the trust (i.e. investors are essentially investing in the mortgages via the trust) and are held on trust for the bondholders.  There are three basic steps to this process,
1. A bank will bundle together and sell loans on its balance sheet to a special purpose vehicle
2. The special purpose vehicle securitises the loans
3. The credit risk is tranched (i.e. divided into triple A, double AA, triple B etc) and sold on to bondholders.
When this type of structure is applied to bonds as opposed to mortgages, it is known as a cashflow CDO.  Cashflow CDOs are the earliest and simplest CDO structure.  They have evolved now into the more common synthetic CDO structure.  In a synthetic structure no legal or economic transfer of ownership of loans takes place.  Instead the bank that wishes to mitigate its balance sheet risk will purchase a credit default swap (“CDS”) from a CDO issuer.

A Credit Default Swap is a bilateral agreement between a protection buyer and a protection seller (the risk taker).  The protection buyer (e.g. a bank) secures protection against losses that may arise in a portfolio of debt obligations of domestic and international corporations.

So rather than selling the physical loan portfolio to the CDO issuer, a synthetic portfolio is created by simply transferring the credit risk in the portfolio to a special purpose vehicle (SPV) via the credit default swap.  The SPV will then bundle up the loan portfolio exposure and sell notes linked to the portfolio (called Credit Linked Notes) to investors.  Consequently, it is the Credit Linked Noteholders that are exposed to credit events in the underlying portfolio. 

Because of the structured nature of Credit Linked Notes (or CDOs), and investor’s credit exposure can be controlled.  This occurs when the credit risk of the synthetic portfolio is tranched and on-sold.  The “thickness” of each tranche will determine the level of risk being  bought.  To align their interest with investors, the arranger of the transaction usually takes the first loss that may arise due to adverse credit events affecting the companies in the portfolio.  After this first tranche any losses are passed on in sequence, depending on the level of risk purchased.

So the returns paid to investors in a structured product can be adjusted depending on where they sit in the capital structure. Looking at this in diagram form, the arranger in the example below will take on the first loss in the portfolio after which any losses up to the notional amount issued are passed on to Tranche C holders.  Tranche B holders will be next in line for any further losses, then Tranche A and so on.  Investors prepared to bear the first losses are paid the highest return.  Investors that take subsequent sets of losses are paid slightly less.  Therefore, commensurate with the extra risk it carries, the yield offered on tranche C should be higher then Tranche B and so on.

Collateralised Debt Obligation - Steps involved
Details of each CDO transaction can be located in the prospectus that precedes quotation on ASX.  Because each CDO issue is unique, close inspection of the prospectus is important before making an investment decision.