A collateralized debt obligation (CDO) is a security that is backed by—or linked to—a diversified pool of credits. The credits can be assets, such as bonds or loans, or simply defaultable names, such as companies or countries. In general, there are two types of CDOs: cash CDOs and synthetic CDOs. A cash CDO is backed by "true" assets, such as bonds or loans. Its payoffs, either coupons or principals, come from the actual cash flows of the assets in the pool. Synthetic CDOs are not backed by cash flows of assets. Instead, they are linked to their reference entities by credit derivatives, such as credit default swaps (CDSs). The payoffs of most synthetic CDOs are only affected by credit events of the reference entities, e.g., defaults, and are not related to the actual cash flows of the pool.
A common structure of CDOs involves slicing the credit risk of the reference pool into a few different risk levels. A "slice" of credit risk, the credit risk between two risk levels, is called a tranche. The tranche that absorbs the first loss (and thus is the most risky tranche) is often called an equity tranche. The remaining tranches are called mezzanine or senior tranches.
A typical feature of a cash CDO is the so-called "cash flow waterfall" structure, where the coupon and/or principal of a tranche is paid only if all the tranches with lower credit risk have been paid off. Such a feature requires a match between the incoming coupons and principals of the pool and the payouts of the tranches. Most synthetic CDOs do not have a cash flow waterfall structure, as such instruments are only concerned with the default loss–this makes structuring, managing and valuing synthetic CDOs easier than cash CDOs. The important implication of such a simplified CDO structure is that tranche customization is possible. Since the payoffs of one tranche do not depend on the payoffs of other tranches, it is easy to structure CDOs with any types of tranches, based on an investor's risk appetite. This makes synthetic CDOs attractive to both CDO investors and managers and has helped the rapid development of the CDO market.
Synthetic CDOs without a cash flow waterfall structure are sometimes called single tranche CDOs. In the rest of this document, the discussion will be limited to single tranche CDOs.
CDO tranches, CDSs on tranches and CDO notes
The risk levels of a synthetic CDO are determined by the total accumulated loss of the reference pool. A tranche is defined as a certain loss range: the lower bound of the range is called an attachment point and the upper bound a detachment point. For example, a 5-10% tranche has an attachment point of 5% and a detachment point of 10%. When the accumulated loss of the reference pool is no more than 5% of the total initial notional of the pool, the tranche will not be affected; however, when the loss has exceeded 5%, any further loss will be deducted from the tranche's notional until the detachment point (10%) is reached. At this point, the tranche is wiped out.
The most common credit derivatives of synthetic CDOs are CDSs and credit-linked notes on CDO tranches. A CDS on a CDO tranche is, to a certain extent, similar to a single-entity CDS. It has a payoff leg and a premium leg. The buyer of a CDS on a tranche will be compensated by the seller for any loss to the tranche and in return the buyer pays a periodic premium to the seller. While the basic structure is similar, there are two fundamental differences between a tranche CDS and single entity CDS:
- In a single-entity CDS the seller will take the full loss of the reference credit, whereas in a CDS on a CDO tranche the seller is protected by the tranches with higher credit risk. In more detail, as long as the total loss of the reference pool does not exceed the attachment point of a tranche, the tranche is not affected. Moreover, the loss to a tranche is limited to its notional, not the total loss of any of the credits in the pool.
- In a single-entity CDS the notional is fixed during the life of the CDS. Conversely, a CDS on a CDO tranche has a non-constant premium notional. When a tranche suffers a loss, the buyer will be paid up to the notional of the tranche and at the same time, for most CDOs, the lost amount will be subtracted from the tranche's notional. The premium payment thus decreases until the notional reaches 0, when the CDS ends.
A similar comparison can be made between a tranche CDS and a basket CDS, such as a first-to-default CDS (for details on basket CDSs see Basket Default Swaps). Like a single entity CDS, a basket CDS pays out on a single credit event and the investor will suffer the full loss if a credit event occurs. The only difference between a basket CDS and a single-entity CDS is the source of risk: the risk to the investor in the latter case is due to all of the entities in the basket. We can say that basket CDSs are more like single-entity CDSs than tranche CDSs. Particularly, one should not confuse a first-loss CDS with a first-to-default CDS. A first-loss CDS is a CDS on the equity tranche of a CDO and, as is pointed out above, is significantly different from a first-to-default CDS.
It should also be pointed out that a first loss CDS is a CDS on the loss of a portfolio of entities up to a certain level. It does not have to be associated with a formal CDO structure, although it can always be viewed as a CDS on the equity tranche of a CDO, i.e., a CDO that has only one tranche, the equity tranche.
FINCAD provides tools to value both CDSs on tranches and CDO notes. CDSs on tranches are valued with both Monte Carlo and quasi-analytic methods. To evaluate an FINCAD product that can value a Collateralized Deb Obligation (CDO), contact a FINCAD Representative