Collateralized debt obligations are complex financial products that bundle multiple bonds and loans into single securities.
These packaged securities are then sold in the market, typically to institutional investors. CDOs became more widely known to the general public due to their role in the 2008-2009 financial crisis.
Individual investors cannot easily buy CDOs. However, the 2008 financial crisis and subsequent recession revealed the interconnected nature of markets, as well as how losses on Wall Street can have ripple effects on the broader economy.
Therefore, it can be important for everyday individuals to grasp the role that complex financial instruments like collateralized debt obligations have in markets.
How Do CDOs Work?
“Collateral” in finance is a term that refers to the security that lenders may require in return for lending money. In collateralized debt obligations, the collateral are the payments from the underlying loans, bonds, and other types of debt.
CDOs are considered derivatives since their prices are derived from the performance of the underlying bonds and loans. The institutional investors who tend to hold CDOs may collect the repayments from the original borrowers in the securities.
The returns of CDOs depend on the performance of the underlying debt. CDOs are popular because they allow lenders, usually banks, to turn a relatively illiquid security — like a bond or loan — into a more liquid asset.
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Tranches in CDOs
CDOs are typically sliced into so-called tranches that hold varying degrees of risk and then these slices are sold to investors.
The most senior tranche is the highest rated by credit rating firms like S&P and Moody’s. The highest credit rating possible is AAA. Holders of the most senior or highest-rated tranche generally receive the lowest yield but are the last group to absorb losses in cases of default.
The most junior tranche in CDOs is sometimes unrated. Investors of this layer earn the highest yields but are the first to absorb credit losses. The middle tranche is usually rated between BB to AA.
Recommended: How Do Derivatives Work?
What Are Synthetic CDOs?
Regular, plain-vanilla CDOs invest in bonds, mortgages, and loans. In contrast, synthetic collateralized debt obligations invest in derivatives.
So instead of bundling corporate bonds or home mortgages, synthetic CDOs bundle derivatives like credit default swaps, options contracts, or other types of contracts. Keep in mind, these derivatives are themselves tied to another asset, such as loans or bonds.
Investors of regular CDOs get returns from the payments made on corporate debt or mortgage loans. Holders of synthetic CDOs get returns from the premiums associated with the derivatives.
CDOs vs CLOs
Collateralized loan obligations are a subset of CDOs. Instead of bundling up an array of different types of debt, CLOs more specifically gather together debt from hundreds of different companies, often this debt is considered below investment grade.
CLOs are considered by some market observers to be safer than CDOs, but both are risky debt products. CLOs do however tend to be more diversified across firms and sectors, while CDOs run the risk of being concentrated in a single debt type, such as mortgage loans during the 2008 financial crisis.
According to S&P, no U.S. AAA-rated CLO has ever defaulted. Also, CDOs can have a higher percentage of lower-rated debt. According to the ratings firm Moody’s, CDOs are allowed to hold up to 17.5% of their portfolio in Caa-rated assets and below (e.g. very high credit risk). That compares to the 7.5% in CLOs.
Collateralized Debt Obligations and the 2008-09 Housing Crisis
CDOs of mortgage-backed securities became notorious during the subprime housing crisis of 2008 and 2009. A selloff in the CDO market was said to amplify broader economic weakness in the economy.
Banks had been weakening lending standards when it came to home mortgages, allowing individuals to buy home that may have been too expensive for them.
Meanwhile, Wall Street banks were packaging home loans — some risky and subprime — into CDOs in the years leading up to the financial crisis. Ratings firms labeled these mortgage-backed CDOs as safe, on the premise that homeowners were a group of creditors less likely to default.
A mortgage-backed CDO holds many individual mortgage bonds. The mortgage bonds, in turn, packaged thousands of individual mortgages. These mortgage CDOs were considered to be of limited risk because of how they were diversified across many mortgage bonds.
But homeowners started to become unable to make their monthly payments, and defaults and foreclosures started piling up, leading to a domino effect of losses spread across the financial system.
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CDO Comeback
Around 2020, CDOs had a resurgence, with primarily corporate loans rather than home loans being packaged into securities.
A world of ultralow yields in the bond market pushed investors to seek higher-yielding markets. The average yield stands at just 2%, while trillions of dollars in debt trades at negative rates. In contrast, CDOs can yield up to 10%.
This time around hedge funds and private-equity firms, rather than banks, became the big players in the CDO market. Hedge funds are the new buyers–accounting for 70% of volume in the market. Banks were responsible for 10% of volumes in 2019, compared with 50% in the past.
💡 Quick Tip: Are self directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).
The Takeaway
Collateralized debt obligations or CDOs are financial structures that bundle together different types of debt and sell shares of these bundled securities to investors.
The return investors might see from these debt-based, derivative securities depends on the ongoing payments from the debt holders. CDOs are typically purchased by institutional investors, not retail investors, but it can be useful to know about this market sector.
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