Collateralized Debt Obligations (CDO)

Collateralized Debt Obligation (CDO) is a generic term used for a security backed by a diversified pool of one or more debt obligations. CDOs backed by corporate bonds and emerging market bonds are called Collateralized Bond Obligations (CBOs), whereas CDOs backed by ABS, RMBS, CMBS, and other CDOs are known as structured CDOs.

CDO Structure

A CDO involves the creation of a Special Purpose Entity (SPE). Then, the CDO manager (or collateral manager) buys and sells debt obligations for and from the CDO’s collateral to meet cash obligations to CDO bondholders.

The source of funds to purchase the collateral assets is the issuance of debt obligations. Debt obligations are a variety of bonds or bond tranches, including senior, mezzanine, or subordinated (equity or junior) bond classes.

A CDO is a leveraged transaction. As such, investors who buy the equity tranche use borrowed funds to generate a return higher than the funding costs.

Example: CDO

To illustrate the structure of a CDO transaction, the following is a $100 million CDO issue example:

$$
\begin{array}{l|c|c}
\textbf{Tranche} & \textbf{Par value (US\$)} & \textbf{Coupon rate} \\
\hline
\text{Senior} & \text{80,000,000} & \text{LIBOR + 50 bps} \\
\text{Mezzanine} & \text{10,000,000} & \text{10-year US Treasury + 300bps} \\
\text{Equity (junior)} & \text{10,000,000} & \text{} \\
\end{array}
$$

Assume that the 10-year US Treasury rate at the time this CDO is issued is 8%, and the coupon rate is the 10-year US Treasury rate + 500 bps.

The collateral pays a fixed rate. However, the senior tranche requires a floating-rate payment.The CDO manager, therefore, enters into an interest rate swap agreement with another party with a notional amount of $80 million to:

• pay a fixed annual rate equal to the 10-year US Treasury + 200 bps; and
• receive LIBOR.

Here is a table summarizing the cash inflows and outflows for each of the tranches in this CDO:

$$
\begin{array}{l|c|c}
\text{Senior} & \begin{array}{c} \text{Interest from swap} \\ \text{= (8% + 5%) × \$100m =} \\ \text{\$13m} \end{array} & \begin{array}{c} \text{Interest to senior tranche} \\ \text{= \$80m × (LIBOR + 50 bps) = \$0.4m +} \\ \text{\$80m × LIBOR} \end{array} \\
\hline
\text{Mezzanine} & \begin{array}{c} \text{Interest from swap} \\ \text{counterparty} \\ \text{= \$80m × LIBOR} \end{array} & \begin{array}{c} \text{Interest to mezzanine tranche} \\ \text{= \$10m × (8% + 3%) = \$1.1m} \end{array} \\
\hline
\text{} & \text{} & \begin{array}{c} \text{Interest to swap counterparty} \\ \text{= \$80 × (8% + 2%) = \$8m)} \end{array} \\
\hline
\text{} & \begin{array}{c} \text{Total: \$13m + (\$80m ×} \\ \text{LIBOR)} \end{array} & \text{Total: \$9.5m + (\$80m × LIBOR)} \\
\hline
\text{Equity (junior)} & \text{Net interest = \$3.5m} & \text{} \\
\end{array}
$$The amount available for distribution to the equity (junior) is whatever is left from the two other tranches less management fees.

Risks Related to CDOs

The risk of default and the risk of a decrease in the coupon rates are prevalent in CDOs. Also, there is always the risk that the manager will fail to earn a return sufficient to pay off the investors in the senior and mezzanine bond classes. In the equity tranche – just like when buying equity in the stock markets – there is the risk that the investor will lose their entire investment.

Question

Which of the following classes carries the highest level of risk?

1. Senior.
2. Mezzanine.
3. Subordinated.

Solution

The correct answer is C.

Subordinated (also called junior or equity) bond classes are residual tranches. Since a CDO is a leveraged transaction, investors in the subordinated tranche risk losing their entire investment.