What Is a CDO
- A collateralized debt obligation is a securitization of a pool of leveraged loans, structured product securities, or other financial collateral.
- The CDO issuer typically is a bankruptcy-remote special purpose vehicle that:
- Issues various classes of rated term debt (with ratings ranging from triple-A to non-investment grade) and un-rated equity in the capital markets.
- Uses the proceeds of this issuance to finance the purchase of a diversified collateral portfolio consisting of bank loans, structured product securities or other collateral.
- Uses cash flows generated by the collateral portfolio to cover expenses, pay down the debt and accrued interest of the issued security, and make distributions to the equity portion of the CDO.
- In simple terms, the CDO issuer borrows money in the capital markets and then attempts to invest the money at higher spreads in the applicable asset market.
- The difference between the after-default yield on the collateral and the funding cost of the liabilities and other expenses is usually captured by the equity class.
- An experienced investment professional, the collateral manager, actively manages the CDO's collateral portfolio.
- The collateral manager selects the initial collateral portfolio and continues to manage it during a reinvestment period.
- The collateral manager seeks to generate high risk-adjusted returns through his/her research, market knowledge, and trading ability, and it is usually paid fees for performing his/her duties.
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