Funds Investing

A collateralized debt obligation (CDO) is backed by a diversified pool of one or more types of debt obligations (e.g., U.S. domestic investment-grade corporate bonds, high-yield corporate bonds, emerging market bonds, bank loans, asset-backed securities, and residential and commercial mortgage-backed securities). The funds to purchase the collateral assets are obtained from the issuance of bonds. There is a collateral manager responsible for managing the collateral of assets.

A CDO is classified as a cash CDO or a synthetic CDO. The adjective “cash” means that the collateral manager purchases cash market instruments. A synthetic CDO is so named because the collateral manager does not actually own the pool of assets on which it has the credit risk exposure. Stated differently, a synthetic CDO absorbs the credit risk, but not the legal ownership, of the reference obligations. A credit default swap allows institutions to transfer the credit risk, but not the legal ownership, of the reference obligations it may own.

Synthetic CDO deals dominate the CDO market in the United States.³ In 1998, roughly $70 billion of both synthetic and cash CDOs were issued. Since 1999 synthetic CDO issuance has far exceeded that of cash CDO issuance. For example, in 2002, cash CDO issuance was $61 billion while synthetic CDO issuance was $209 billion.Moreover a CDO can be arbitrage motivated (i.e., “arbitrage CDOs”) or balance sheet motivated (i.e., “balance sheet CDO“). Today, synthetic arbitrage deals dominate the market.

A synthetic CDO works as follows. There are liabilities issued as with a cash CDO. The proceeds received from the bonds sold are invested by the collateral manager in assets with low risk. At the same time, the collateral manager enters into a credit default swap with a counterparty. In the swap, the collateral manager will provide credit protection (i.e., the collateral manager is the protection seller) for a basket of reference obligations that have credit risk exposure. Because it is selling credit protection, the collateral manager will receive the credit default swap premium.

On the other side of the credit default swap is a protection buyer who will be paying the swap premium to the collateral manager. This entity will be a financial institution seeking to shed the credit risk of assets that it owns and that are the reference obligations for the credit default swap.

If a credit event does not occur, the return realized by the collateral manager that will be available to meet the payment to the CDO bondholders is the return on the collateral consisting of low-risk assets plus the credit default swap premium. If a credit event occurs that requires a payout, the collateral manager must make a payment to the protection buyer. This reduces the return available to meet the payments to the CDO bondholders.

CREDIT-LINKED NOTES

^{A credit-linked note (CLN) is a security issued by an investment banking firm or another issuer (typically a special-purpose vehicle) which has credit risk to a second issuer (called the reference issuer), and the return is linked to the credit performance of the reference issuer. Embedded in a CLN is a credit derivative, typically a credit default swap.}

^{A CLN can be quite complicated, so we will focus on the basic structure only. The issuer of a CLN is the credit protection buyer; the investor in the CLN is the credit protection seller. The basic CLN is just like a standard bond: It has a coupon rate (fixed or floating), maturity date, and a maturity value. However, in contrast to a standard bond, the maturity value depends on the performance of the reference issuer. Specifically, if a credit event occurs with respect to the reference issuer then (1) the bond is paid off and (2) the maturity value is adjusted down. How the adjustment is made is described in the prospectus. The compensation for the investor accepting the credit risk of the reference issuer is an enhanced coupon payment.}

^{Typically, CLNs have a maturity of anywhere from three months to several years, with one to three years being the most likely term of credit exposure. The short maturity of CLNs reflects the desire of investors to take a credit view for such a time period.}

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