A collateralized debt obligation refers to a security backed by a diversified pool of one or more debt obligations.
Depending on the collateral, a collateralized debt obligation has the following types:
- Collateralized bond obligations: backed by corporate and emerging market bonds
- Collateralized loan obligations: backed by leveraged loans
- Structured finance CDOs: backed by ABS, RMBS, CMBS and other CDOs
- Synthetic CDOs: backed by credit default swaps.
Tranches of a CDO
A CDO is managed by a manager called collateral manager, which creates a CDO by issuing different tranches (senior, mezzanine and subordinated) of the CDO and invests the proceeds in different debt obligations.
The senior and mezzanine tranches attract investors who want to obtain exposure to debt obligations which they cannot purchase directly.
The subordinated tranche is also called residual/equity tranche because it has equity-like return characteristics. A CDO is effectively a highly-leveraged transaction from the perspective of the equity tranche.
Role of the collateral manager
The objective of the collateral manager is to earn a return higher than the cost of all classes and the CDO. He is subject to various tests and limits, failing which a provision triggers the return of principal to senior tranches which effectively de-levers the CDO. The cash flows made to the different bond classes come from interest payments on collateral, maturing collateral assets and sale of collateral assets.
Risks of a CDO
A CDO is not without risk: if the securities held as collateral default, the senior and mezzanine tranches may not receive the promised payments, the return may be less than expected and the equity tranche may be wiped out altogether. Further, the CDO manager needs to properly plan for the return of principal to the senior and mezzanine tranches.