Collateralized Debt Obligations

A CDO is a special purpose company or vehicle (SPV), complete with assets, liabilities and a manager. Typically, the CDO’s assets consist of a diversified portfolio of illiquid and credit-risky assets such as high yield bonds (CBO) or bank leverage loans (CLO).

We have set up a typical CDO structure in Figure 1. The assets are transferred to the SPV that funds these assets, from cash proceeds of the notes it has issued. The CDO structure allocates interest income and principal repayment from a pool of different debt instruments to a prioritised collection of securities notes called tranches. Senior notes are paid before mezzanine and lower rated notes. Any residual cash flow is paid to the equity piece. This makes the senior CDO liabilities significantly less risky than the collateral.
On every payment date, equity receives cash distributions after the scheduled debt payments and other costs have been paid off. The equity is also called the “first-loss” position in the collateral portfolio. This is because it is exposed to the risk of the first dollar loss in the portfolio. The CDO rating is based on its ability to service debt with the cash flows generated by the underlying assets. The debt service depends on the collateral diversification and quality guidelines, subordination and structural protection (credit enhancement and liquidity protection).As we move down the CDO’s capital structure, the level of risk increases. The equity holders that bear the highest risk have the option to call the transaction after the end of the non-call period, which in most cases lasts three to five years.
The typical CDO consists of a ramp -up period, during which the collateral portfolio is formed, a reinvestment period, during which the collateral portfolio is actively managed, and an unwind period, during which the liabilities are repaid in order of seniority using collateral principal proceeds. During the reinvestment phase, the equity class distributions consist of excess interest on the full portfolio, minus collateral interest income remaining after the payment of debt interest and other fees. The manager would reinvest collateral principal proceeds. In the repayment period, excess interest payments gradually decrease as the collateral portfolio principal proceeds are used to repay the debt in order of seniority. After all the debt classes have been redeemed, and if the equity class has not elected to call the transaction, the remaining principal payments pass to the equity. Figure displays an example capital structure, where the high yield bonds collateralise CDO liabilities.

                                                                         Figure: CDO Capital structure