What are ‘Collateralized Debt Obligations’?

Many investors prefer making debt instruments investment to generate stable returns. They can facilitate portfolio stability as well as diversification. However, many people want to avoid the risks that come with direct investments. 

For them, collateralized debt obligations can be an excellent choice. Find out more about this financial asset by reading this blog. 

‘Collateralized Debt Obligations’ – Meaning and Structure

‘Collateralized Debt Obligations’ (CDOs) are a type of derivative financial contract that derives its value from a combination of debt instruments. They may include bank loans, sovereign bonds, corporate bonds, etc. 

Investment banks, which have a detailed insight into these assets, generally issue CDOs. They locate cash-generating debt instruments and pool them together in one financial product. According to the credit rating agency’s risk methodology, CDOs are evaluated in accordance with the credit risks that they pose.

Credit rating agencies generally provide these scores based on the creditworthiness of the obligation. The securities with a higher rating, like AAA, have fewer involved risks and thus will provide lower returns. Inversely, the CDOs having lower ratings like B will have higher risks and thus higher returns on investment.    

Thus, if the underlying debt instrument defaults, investors who hold senior category assets will be first on the repayment priority list, followed by mezzanine and junior.   

How do CDOs work?

To create collateralized debt obligations, banks and other financial institutions create a collection of debt instruments and sell them on the secondary market. The entire process is highly complex and involves several other entities. 

The pooling process requires quantitative analysis and high-level computer modelling by a group of financial experts. After this, banks assign values to their packages and hire a group of professionals to introduce them to the market.

Next, a CDO manager is appointed, who is responsible for determining which securities will serve as collateral. From here, the securities firm assesses the chosen collateral and based on it, provide their approval. Additionally, they also help structure these assets into tranches. 

Hereafter, credit rating agencies classify the collateralized debt obligations according to their risks and assign them appropriate scores. Then, financial guarantors are appointed to facilitate reimbursements to investors in case they incur any losses from the premium payments. 

Now, if there is a situation of default, the underlying securities become collateral for the asset holders. Banks create CDOs to offer investors a financial asset which can provide them with a regular stream of income. Interest payments by the original borrowers serve as the source in this regard. 

As collateralized debt obligations are a culmination of various loans into one product, when investors buy them, they become the legal owners and are entitled to interest payments from the borrowers.  

These investment vehicles are only purchasable by institutional investors. They may include hedge funds, insurance providers, investment managers, pension funds and more. 

Types of CDOs

CDOs can be classified into the following types depending on the type of underlying debt security:

Advantages of investing in CDOs

• High liquidity

There are a large number of buyers and sellers that trade using collateralized debt obligations. Thus, you can easily sell off your holdings in the secondary market whenever you feel like exiting your position. 

• Diversification of risk

These investment vehicles contain a pool of debt instruments as their underlying asset. Thus, they serve as an excellent means to diversify the risks in your portfolio. 

• Priority for repayment 

Another significant benefit of investing in CDOs is the repayment priority that you can get by purchasing senior category debt instruments. Although the return rates are lower in comparison to the other options, it is a great choice if you are a low-risk investor.  

Disadvantages of investing in CDOs

• Difficulty in assessing returns

As you already know, the pooling procedure for collateralized debt obligations is very complex. Moreover, there is an overall lack of transparency in the financial market when it comes to these assets. 

Thus, it becomes very difficult for investors to assess the price movements of the underlying securities and assess the risk and return potential. 

• Devaluation risks 

As the underlying assets for CDOs are debt securities, in case any of these assets default or depreciate in creditworthiness, there can be a negative impact on the asset value. Furthermore, as these investment vehicles have a fixed interest rate, their values can depreciate with rising rates of interest. 

Final Word

Investing in collateralized debt obligations can be an excellent way to expose your portfolio to multiple debt instruments. However, before you invest, it is crucial that you consider the factors that affect these investment vehicles and allocate your funds accordingly.  

Frequently Asked Questions