Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
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Collateralized debt obligations, or CDOs, are asset-backed securities that bundle traditional forms of debt, like loans, mortgages, and bonds. A synthetic CDO, however, invests in non-cash derivatives — such as credit default swaps, options, and insurance contracts — and generates income from investor premiums.
Synthetic CDOs are a high-risk investment (as are regular CDOs), owing to the high risk of default, and are typically not available to retail investors. They are often viewed as controversial; many have attributed the use of synthetic CDOs to the 2008-09 financial crisis and subprime mortgage collapse.
Here’s a closer look at how synthetic CDOs work and the risks associated with investing in them.
Key Points
• A synthetic CDO invests in credit derivatives, like credit swaps, without owning underlying assets.
• Synthetic CDOs have tranches reflecting different risk levels, with higher ratings indicating lower risk as well as lower returns.
• Due to their complexity and risk, synthetic CDOs are used mainly by institutional investors.
• Synthetic CDO instruments are considered high-risk, in part due to market risk and the potential for the underlying assets to default.
• Synthetic CDOs have been criticized for contributing to the subprime mortgage collapse that led to the 2008 financial crisis.
What Is a Collateralized Debt Obligation (CDO)?
A CDO or collateralized debt obligation is a type of derivative, meaning it derives its value from an underlying financial asset or pool of assets such as credit card debt, auto loans, mortgages, and so on. As people pay their debts, investors who own these asset-backed securities may see a steady cash flow from those payments.
How Does a CDO Work?
CDOs are considered derivatives as their value (and price) derives from the quality of the underlying debt instruments. In essence, a CDO is a bundle of debt that’s sold to investors on the secondary market. Rather than individual investors, CDOs are typically sold to institutional investors, such as insurance companies or investment banks.
A CDO divides the underlying debt into so-called tranches that are rated according to different credit risk levels (e.g., Senior AAA, Junior AAA, AA, A, and so on). The safest tranches are highly rated, but generate lower payments. Also, investors who own a certain tranche receive the principal and interest payments according to seniority.
Because debt payments tend to be predictable, the appeal of CDOs is the potential for cash flow. But the risk in these types of financial assets lies in the potential for people to default on their debts. In the case of a default where there isn’t enough cash to cover all the payments for a certain tranche, the higher or more senior tranches are paid first and lower tranches may see losses first.
Different Categories of CDOs
Collateralized debt obligations are considered a type of alternative asset, in that they’re not part of the world of traditional securities like stocks and bonds.
CDO categories may include:
• Mortgage-backed securities, which are comprised of mortgage loans
• Asset-backed securities, which invest in non-mortgage debt, such as credit cards or car loans
• Collateralized bond obligations, which hold a mix of bonds.
As noted above, CDOs are assigned a tranche or class which signifies the level of risk and reward. The highest rating is AAA, which signifies the lowest risk but correspondingly, the lowest yields, something to bear in mind when investing online or through other channels.
CDOs and the Financial Crisis
CDOs contributed to the 2008 financial crisis because many of them concentrated holdings in high-risk assets, namely, subprime mortgages. Banks flocked to CDOs because they offered diversification and generated cash flow, which was used to make new loans.
When the housing bubble burst, however, declining home values led many borrowers to default on their subprime loans. That resulted in a rapid cooling of the CDO market and substantial losses for banks.
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Understanding Synthetic CDOs
Unlike traditional CDOs, which invest in assets that receive and generate cash payments from debt products like mortgages and other loans, synthetic CDOs attempt to generate cash flow without ownership of the underlying assets.
Instead, a synthetic CDO offers investors exposure to non-cash credit derivatives, such as credit default swaps, insurance contracts, or options. The idea is that a synthetic CDO can generate income from premiums paid by investors.
Like regular CDOs, synthetic CDOs are assigned tranches relative to the level of risk they present. The higher the credit rating, the lower the risk, but the return profile is also lower.
How a Synthetic CDO Works
Consider a typical synthetic CDO that invests in credit default swaps. A credit default swap is a contract in which a buyer pays a premium to the seller, and the seller agrees to pay a lump sum to the buyer if the underlying credit instrument defaults.
In this type of arrangement, the seller of the synthetic CDO assumes a long position, betting that the underlying assets will perform as expected. The buyer assumes a short position, betting that the underlying assets will default. If the asset defaults, the buyer is entitled to a payout from the seller.
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Investing in Synthetic CDOs
Synthetic CDOs are not designed for the everyday investor. If you’re interested in self-directed investing, for example, you won’t find them offered alongside individual stocks or exchange-traded funds (ETFs) at a traditional brokerage.
More often, synthetic CDOs are the domain of institutional investors like banks or insurance companies. That’s appropriate, given how complex these products are.
Individual investors who are interested in diversifying their asset allocation with alternative investments can gain exposure to credit default swaps outside of a synthetic CDO. For example, you might invest in an ETF or mutual fund that holds credit default swaps as an underlying asset.
There are, however, some stipulations. Venturing into this type of alternative investment is generally not recommended for investors who don’t fully understand how they work or the risks involved.
What Are Alternative Investments?
Alternative investments, sometimes called alts, refer to non-traditional assets that fall outside the realm of stocks, bonds, and cash. Alts may include commodities, real estate, private equity, hedge funds, and derivatives such as options, futures, and CDOs.
Alts typically have little or no correlation with traditional asset classes. Thus they can be appealing to some investors because they may offer some portfolio diversification, and the potential for higher risk-adjusted returns.
That said, alts tend to be illiquid, not transparent, not well-regulated, and high risk.
Risks of Investing in Synthetic CDOs
Like most types of alternative investments, synthetic CDOs carry elevated levels of risk for investors.
Some of the most significant risks include:
• Lack of transparency and limited federal regulation
• Credit risk and the potential for default of underlying assets
• Liquidity risk and the difficulties in buying and selling synthetic CDO positions
• Modeling risk, which can result in incorrect assumptions about the value of underlying assets
• Market risk, or the risk of changes in the value of underlying assets
While the market has changed in the years since the financial crisis, and federal regulations now exist to protect investors from a repeat of those events, the risks of synthetic CDOs and CDOs in general can’t be discounted.
The Takeaway
Synthetic CDOs are a complicated way to build a portfolio. If you’re looking for a way to diversify, you can invest in stocks, ETFs, private credit, commodities, and even IPOs through an online brokerage account.
SoFi does not offer CDO investments at this time, but it does provide access to a range of alternative investment funds. You can choose what to invest in, based on your risk tolerance and goals.
Ready to expand your portfolio's growth potential? Alternative investments, traditionally available to high-net-worth individuals, are accessible to everyday investors on SoFi's easy-to-use platform. Investments in commodities, real estate, venture capital, and more are now within reach. Alternative investments can be high risk, so it's important to consider your portfolio goals and risk tolerance to determine if they're right for you.
FAQ
What is the main purpose of a synthetic CDO?
The main purpose of a synthetic CDO is to allow investors to see cash flow from premium payments on underlying credit assets without owning them. Synthetic CDOs that invest in credit default swaps allow a buyer and seller to take short and long positions respectively to bet on the behavior and performance of the underlying asset.
How do synthetic CDOs differ from traditional CDOs?
Traditional CDOs invest in cash-based debt instruments or securities, such as mortgage loans, credit card debt, or auto loans. Synthetic CDOs primarily invest in non-cash credit instruments, such as credit default swaps or options.
What are the risks associated with investing in synthetic CDOs?
Synthetic CDOs are subject to default risk, market risk, and liquidity risk. If the underlying asset doesn’t perform as expected, that can result in losses for the buyer or seller.
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