Collateralized debt obligations and CLOs

What is a CDO?

A collateralized debt obligation (CDO) issues tranched securities backed by a pool of debt. The pool is managed: a collateral manager buys and sells assets within selection rules. Names follow the collateral.

Collateralized debt obligation (CDO)tranched securities backed by a managed pool of debt

• CLO (loans) Memorize leveraged (senior secured) bank loans; the dominant type today
  • Cash flow CLO Use it pays from interest and principal; the most common
  • Market value CLO Use it pays from trading the portfolio
  • Synthetic CLO Use it exposure through credit derivatives
• CBO (bonds) Memorize corporate and emerging-market bonds
• Structured finance CDO Use it other asset-backed securities (ABS), mortgage-backed securities (MBS) or CDO tranches
• Synthetic CDO Use it credit default swaps referencing debt, not the debt itself

Type	Collateral
Collateralized loan obligation (CLO)	Leveraged (senior secured) bank loans: the dominant type today
Collateralized bond obligation (CBO)	Corporate and emerging-market bonds
Structured finance CDO	Other asset-backed securities (ABS), mortgage-backed securities (MBS) or CDO tranches
Synthetic CDO	Credit default swaps referencing debt, not the debt itself

CLOs come in three common flavors. A cash flow CLO redistributes the interest and principal collected on the loans across the tranches, and it is the most common. A market value CLO pays tranches according to the market value of the portfolio. A synthetic CLO builds its pool with credit derivatives.

Before 2008, CDO pools held a wide mix of assets, including real-estate debt. Structured finance CDOs, built from other CDOs, are now rare, and synthetic CLOs are less common than cash flow CLOs. Today’s pools are mostly leveraged loans.

How does a CLO make money?

Use it

A CLO works when the loans earn more than the debt tranches cost. The equity tranche is the lowest tranche: unrated, with no set coupon, and entitled to all excess cash flow once the debt tranches are paid. Because it also takes the first losses, it is a leveraged claim on the pool.

CLO tranches, highest claim firstpaid top down, hit by losses bottom up

• Senior (AAA) debt Memorize lowest yield, most protected
• Mezzanine debt (AA to BB) Use it higher coupons, more exposed to loss
• Equity tranche Memorize unrated; no set coupon; keeps all excess cash flow and takes first losses

Write P for the pool, y for its yield, D for the debt, c for its average cost, f for the manager fee and l for default losses (both as shares of the pool), and E for the equity.

$$X = P\,y - D\,c - P\,f - P\,l$$

$$R = \frac{X}{E}$$

Exam tip Equity return is the residual divided by the equity, not by the pool. Do the residual first, then divide by the small tranche.

What do the manager and the tests do?

Memorize

The collateral manager builds the pool: most of the loans are bought before closing, and the rest during the ramp-up period after it. Afterwards the manager may trade, as long as new assets meet the selection criteria. At the end, loans mature and the proceeds repay the tranches in order.

Coverage tests check that the pool’s value and income are enough for the debt. If a test fails, the CLO diverts cash away from equity and junior debt and uses it to pay down the senior notes until the test passes. That deleverages the deal, because the senior notes are its cheapest funding, and it protects senior holders. Each debt tranche usually has its own overcollateralization test, measured against the notes at and above it.

$$\text{OC ratio} = \frac{\text{Collateral par}}{\text{Par of the notes tested}}$$

Investors’ recourse is limited to the pool. Senior and mezzanine investors earn a yield above similar corporate bonds, and equity investors take equity-like risk and return. The collateral manager’s skill matters a great deal, because the manager is in effect running an active portfolio of loans.

Go deeper Why the equity tranche decides whether a CLO exists

A CLO sells debt only if someone buys the equity. The equity buyer must expect a competitive return, which depends on the gap between loan yields and the cost of the debt tranches. If that gap is too narrow, the equity cannot be sold and the deal is not launched.

Go deeper Reinvestment period, then amortization

For the first years after closing, a CLO usually keeps reinvesting repaid loans in new ones. After the reinvestment period ends, loan repayments pay the tranches off from the top down, so the deal runs down as the loans mature.

Go deeper Synthetic CDOs and credit default swaps

A synthetic CDO does not own the debt. It sells protection through credit default swaps referencing the debt and passes the premiums and the losses to its tranches. Credit default swaps are covered in the Derivatives topic.