Guide to Collaterized Debt Obligations

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Collateral debt obligations (CDOs) are securities that allow utilization of a single instrument covering various companies to be made available in tranches (slices), with bonds as their underlying risks.

This is done based on the risk criteria of the companies involved, as such the lower the risk the higher the coupon payments and interest rates. Introduced in 1987 the collateral debt obligations soon became very popular in the asset backed synthetic securities market, this is due to their attractiveness as a form of investment.

Many organizations which include commercial banking institutions, mutual fund companies, insurance companies and investment banks have all shown great interest in the CDOs.

And although these securities are basically the same in principle, CDOs also come in varying shapes and sizes, that is their underlying structure and assets can differ dependent on how a given collateral debt obligation is defined and packaged.

Essentially, the idea behind them as with all credit derivatives is for the originator of the underlying assets to transfer credit risk to a third party, be they organizations or individual investors.

Tranches (synthetic) of  CDOs can be funded or unfunded, in this case any credit event occurring in the course of the agreement will have to be paid for. And the distinction lies with such payments because typically high risk tranches are unfunded and they only pay up at the very end (at closing).

Interest charges pertaining to the collaterized debt obligations are normally covered by earnings derived from liquid assets (CDOs are asset based securities) stashed in Guaranteed Investment Contract (GIC) accounts, so any required payments are drawn from it.

On the other hand, hybrid CDOs delivery portfolios are structured to involve both cash and swaps allowing the CDOs to access more assets. While some payments are derived from sources other than the Guaranteed Investment Contract (GIC) – through CDS premiums and also the return on cash assets.

Organizations and individuals investing in senior tranche (low risk debt) do so to realize better returns compared to other investment options falling in the same segment such as corporate bonds.

Typically, senior levels of debt are in a position to pay an investor a spread exceeding LIBOR. On the other end of the stick, junior tranche offers a leveraged, non recourse investment as regards the underlying diversified collateral portfolio.

And the different types of collateral include the emerging market sovereign debt, project finance debt, trust preferred securities, corporate bonds, leveraged loans, real estate investment trust, the commercial real estate mortgage debt and the structured finance securities.



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