Securitisation: Introduction to Collateral Debt Obligations (CDOs)

Background

A CDO is a securitised product that allows investors to gain exposure to an underlying, diversified pool of assets (debt instruments). CDOs is a very broad category that includes many other more granular products.

For instance, if the underlying assets that make up the CDO are loans, then the CDO would be known as a Collateralised Loan Obligation (CLO); if it were mortgages, then it would be known as a Mortgage-Backed Security (MBS).

CDOs follow the same set up that we have previously seen in the series with the issuer of the CDO setting up a special purpose vehicle (SPV) and a portfolio manager tasked to identify the underlying securities.

CDOs come in many flavours, and they can address different investor needs. They can be made up of multiple tranches, allowing investors to vary their risk-return profiles in what is known as a ‘Waterfall Cash Flow Structure’, or they can be Single Tranche.

Types of CDOs

CDOs are often split into two groups: Cash and Synthetic.

Cash CDOs are made up by actual assets, such as bonds, loans, etc. whereas Synthetic CDOs are made up by other derivative products (such as Credit Default Swaps (CDSes), Options, etc.).

Note: Credit Default Swaps is a derivative product that offers insurance against credit events (think Default).