Collateralized Debt Obligation (CDO)
The Indian financial market is termed the ‘Market for Everyone’, as it includes financial instruments that can cater to the financial needs of every type of investor. The creators of such financial instruments also ensure that the people who invest achieve their financial goals by mitigating the risk profile attached to the investments or financial transactions they have carried out.
Some instruments, such as stocks or bonds, are easier to understand and invest in. However, investment banks create an investment instrument called Collateralized Debt Obligation (CDO) as a complex financial product to mitigate their risk profile and offer a diversified debt product to institutional investors.
This blog will help you understand Collateralized Debt Obligation (CDO) definition along with providing you with the answer to what is a CDO.
What are Derivatives?
Derivatives are financial contracts that derive their value from an underlying asset such as stocks, commodities, currencies etc. They are set between two or more parties, where the value of the derivative is derived from the price or value fluctuations of the underlying assets. Derivatives can be used to hedge a position, speculate on the directional movement of an underlying asset, or leverage holdings. There are two types of derivatives: Futures and Options.
Derivative trading happens over the counter or via an exchange. Over-the-counter trading works between two private parties and is not regulated by a central authority. Furthermore, as two private parties agree on the contract, it is susceptible to counterparty risk. This risk refers to the possibility or rather the danger of one of the parties defaulting on the derivative contract.
What is Collateralized Debt Obligation (CDO)?
A Collateralized Debt Obligation (CDO) is a type of derivative contract and is a synthetic investment product that groups different types of loans to offer a single investment product to institutional investors. Collateralized debt obligation (CDO) clubs various loans and derives its value from an underlying asset.
In case the loan defaults, these underlying assets become the collateral for the holders of the collateralized debt obligation (CDO). As the collateralized debt obligation (CDO) includes numerous types of loans, the holder of the CDO is the one who collects the borrowed amount from the original borrower, in theory, at the end of the tenure of the collateralized debt obligation (CDO).
Understanding collateralized debt obligation (CDO)
The first creation of collateralized debt obligation (CDO) dates back to 1987 when investment bank Drexel Burnham Lambert created the first CDO by clubbing junk bonds issued by various companies together. However, collateralized debt obligations (CDOs) are now widely used to offer complex yet rewarding financial products to institutional investors. CDOs are called ‘collateralized’ because the repayment that is offered on the underlying assets is the collateral that gives the value to the collateralized debt obligations (CDOs).
The main idea behind creating a collateralized debt obligation (CDO) is to offer a regular income stream to the holders of CDOs. The income comes from the regular interest the borrowers have to pay on the initial loan. The lender clubs various loans, such as automobile loans, student loans, bonds etc., together and creates a single product. Institutional investors then buy the product and are termed as the legal owner of the products. From thereon, the holders of the collateralized debt obligations (CDOs) have the right to realise the interest payments offered by the original borrowers.
The Structure of Collateralized Debt Obligation (CDO)
The collateralized debt obligation (CDO) is created by investment banks that have extensive financial knowledge about investment products. These investment banks identify cash-generating assets such as bonds, mortgages, loans etc., and group them to create a single financial product.
The collateralized debt obligation (CDO) is offered to institutional investors in tranches or discrete classes based on the credit risk attached to every CDO. These tranches or classes then become the final products and reflect their included type of debt. For example, MBS (mortgage-backed securities) include various mortgage loans with different underlying assets or collateral, while an ABS (asset-backed securities) include various loans such as auto loans, credit card debt, corporate loans etc.
These collateralized debt obligations (CDs) are named to reflect their risk profile. Listed below are the names of collateralized debt obligations (CDOs) and their rating based on their creditworthiness:
The above table depicts the structure of a collateralized debt obligation (CDO) where a higher credit rating results in a lower coupon rate. It is because the creator of collateralized debt obligation (CDO) attaches a higher coupon rate to a low rated CDO to attract investors with potentially higher returns. Furthermore, if the loan defaults, the senior holders are paid before anyone else from the collateralized pool of assets. Only after the senior holders are paid the holders in the other tranches, such as mezzanine and junior are, paid according to their credit ratings. The lower the rating, the lower the repayment priority.
Generally, the underlying assets in a collateralized debt obligation (CDO) are corporate bonds (bonds issued by private organisations ), sovereign bonds (bonds issued by the government) and bank loans (loans taken from the bank for personal purposes).
Advantages of Collateralized Debt Obligation (CDO)
A collateralized debt obligation (CDO) is an effective investment instrument that allows the creator to reduce the overall risk attached to various debt products. Here are the advantages of collateralized debt obligations (CDOs):
Repayment Risk: Collateralized debt obligations (CDOs) allow lenders such as banks to lower their risk profile effectively on the balance sheet. As the majority of banks are legally bound to have a certain amount of their assets as a reserve, they can create a collateralized debt obligation (CDO) to ensure the securitisation of assets and its sale as it becomes costly to hold them in reserve.
Repayment Priority: Investors who invest in a collateralized debt obligation (CDO) can ensure that the creator prioritises them in the case of loan default. It can be done by being in the senior tranche of the collateralized debt obligation (CDO) and by avoiding investing in a lower-rated bond because of its high coupon rate.
Liquidity: A single bond held by a bank may become highly illiquid without finding a buyer. A collateralized debt obligation (CDO) allows banks to find liquidity for individual contracts such as a single bond by grouping it with other debt and creating a single investment product.
Collateralized Debt Obligation (CDO) is an effective product that groups various debts and creates a diversified financial product. It can become a source of regular income to the holders who directly get the interest payments done by the original borrowers. Furthermore, if the tranche is senior, an collateralized debt obligation (CDO) ensures that the investor is paid before anyone else, resulting in a safe investment process. However, as the structure of a collateralized debt obligation (CDO) is deemed complex, you must invest in one only after understanding the collateralized debt obligation (CDO) meaning in detail.
Frequently Asked Questions Expand All
CDO is a type of derivative where various debts such as loans are grouped to create a single diversified debt product.
CDOs are now more commonly known as bespoke tranche opportunity.
The primary difference between the two is the underlying asset. While CLO uses corporate loans as underlying assets, CDOs use mortgages.
CDS are credit default swaps that provide insurance-like protection against the event of default. CDOs are a type of derivative where various debts such as loans are grouped to create a single diversified debt product.