What Are Collateralized Debt Obligations (CDOs)?

Collateralized debt obligations (CDOs) have been receiving a lot of attention over the past couple of years. Before the great financial collapse of 2008 the market for collateralized debt obligations was the largest market. This market was even bigger than the U.S. Treasury. However, because most CDOs are considered derivatives their value literally evaporated overnight. 

What is a CDO ?

A CDO is a bond that is backed by some form of collateral, like mortgages or loans. The CDO creates a structure like a corporation with the sole purpose of creating an investment vehicle with different class investors. In this way, it is a series of bonds, equity instruments, and derivatives.

The Structure of a CDO

Every month, the CDO produces a cash flow from the collateral of loans, or mortgages. This cash flow is then distributed to investors. The entire structure of the deal is allocated into what's known as tranches. Each tranche has its own series of class of investors which are apportioned a certain portion of the investment. Because the CDO is so complicated, different characteristics of normal investments apply to each tranche, or class of investor.

For instance, just like debt instruments, the collateralized debt obligation will play senior debt investors, then junior debt investors and finally equity investors. This can be imagined as an upside down pyramid where the senior debt holders will receive the bulk of the cash flow each month. If the CDO is performing well the bottom of the pyramid, the equity investors will receive a great rate of return after all the debt holders receive their payments as proscribed by the prospectus at origination of the deal.

Each tranche has its mix of credit quality of the deal. Some of the debt may be rated triple A, some of the deal may be rated junk bond status. It is all a matter of financial engineering because this form of investment is considered most likely a hybrid investment. The investment can show different characteristics; such as, equity, debt and derivative vehicles.

Who Invests in CDOs

Most investors are not able to partake in the CDO investment, so most investors in this market are professional and private investors. Many of these class of investments have top hat investors who deal through private banks in order to receive information or prospectuses for these types of investments. In other words, milllionaire investors and institutional investors are the primary target market for collateralized debt obligations.

CDOs used to be very popular because of their higher percentage bond return for triple A grade bonds. There is also tax benefits for investing in this class of hybrid bonds. You can talk to your CPA for more information about some of the tax benefits. 

Risk of a CDO

As with any investment, the higher the reward, the higher the risk. The underlying risk of a CDO is great because it is tied to debt obligations, In a bad economy, a CDO can lose most of its value so it is best to leave this type of investment to the professionals.

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