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CDO Investment Structures
Most new investment vehicles evolve as dealmakers start tinkering with the original structure to provide attractive alternatives to investors. Usually, complexity increases with each new structure introduced, and the general rule is, where there is increased complexity there is increased risk - and opportunities.
CDOs have evolved since first introduced in the 80s, mostly as a result of improved CDO technology and information. Many different asset classes and structures exist today, primarily because information is now available such as, default and recovery statistics, credit rating migration studies, and correlation analyses. And the technology can process, evaluate and model this wealth of information.
A typical CDO is a diversified pool of assets used to create three tranches, each with a different risk profile, depending on their priority to receive the pool cash flows. The impact of defaults is felt by the tranches in reverse order, with relation to seniority. In a recent Institutional Investor article, John Flynn, Vice President of GE Asset Management illustrated and explained a sample structure:
Income generated from the CDO's assets is used to pay all debt investors, and any fees and expenses. The remaining cash flow is paid to the equity investors. Principal and interest payments made on the portfolio collateral are distributed to investors based on the priority of payments schedule.
The liabilities will usually consist of several debt classes, with various credit ratings and coupons that provide investors several options to meet their risk and return parameters and a single layer of unrated equity.
Equity investors have a subordinated claim on the CDO's cash flows and have leveraged exposure to the portfolio collateral. To assume this risk, equity investors would expect returns above 15%.
CDOs can take two forms, cash flow or synthetic:
- Cash Flow Vehicles: Investor capital is used to directly purchase the portfolio collateral. Cash flow generated by the assets is used to make principal and interest payments to the debt and equity investors. The underlying assets are not marked to market, but are held at par unless a credit event occurs.
- Synthetic Vehicles: Usually off-balance sheet transactions that involve an exchange in cash flows through a credit default swap or a total return swap. The CDO sells credit protection, or promises the return of par after a credit event and receives all cash generated on the portfolio less financing costs paid to the swap counterparty.
Examples of other CDO structures that have evolved, include:
- CDO of CDOs: This structure is identical to a conventional CDO, except the underlying assets consist of tranches from previous CDOs. If the primary assets default, the impact is first felt by the CDO's first line of defense - the equity tranche of the conventional CDO that holds those particular assets.
- Single Tranche CDO: This structure is a tranche of a synthetic CDO, without a fully distributed liability structure.
When looking at investment opportunities, investors need to look at the credit quality of the underlying assets, make a decision on whether you want a debt or equity investment in your portfolio, and what your risk/return appetite is.
SS&C's enterprise portfolio accounting and reporting system, CAMRA, has a number of features which support the handling of CDO securities, including the means to process non-standard cash flows.
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This article first appeared in the 2/11/2005 edition of our Asset Management eBriefing.
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