1、Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-1Chapter 16Collaterized Debt Obligations Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-2Learning ObjectivesAfter reading this chapter, you will understandwhat is meant by a collateralized debt obligation, col

2、lateralized bond obligation, and collateralized loan obligationthe structure of a collateralized debt obligation and the role of the collateral managerthe difference between an arbitrage and balance sheet transactionthe economics underlying an arbitrage transactionthe motivation for a balance sheet

3、transactionCopyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-3Learning Objectives (continued)After reading this chapter, you will understandthe difference between a cash flow transaction and a market value transactionthe types of restrictions imposed on management in a collaterali

4、zed debt obligationthe difference between a cash and synthetic transactionthe need for an interest-rate swap in a cash transactionthe role of a credit default swap in a synthetic transactionCopyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-4Structure of a CDOIn a collateralized bo

5、nd obligation (CDO) structure, there is a collateral manager responsible for managing the portfolio of debt obligations.The portfolio of debt obligations in which the collateral manager invests is referred to as the collateral.In individual issues held that comprises the collateral are referred to a

6、s the collateral assets.The funds to purchase the collateral assets are obtained from the issuance of debt obligations.These debt obligations are referred to as tranches.The tranches include senior tranches, mezzanine tranches and subordinate/equity tranche.A CDO may or may not have a mezzanine tran

7、che.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-5Structure of a CDO (continued)For the senior tranches, at least an A rating is typically sought.For the mezzanine tranches, a rating of BBB but no less than B is sought.The subordinate/equity tranche receives the residual cash

8、 flow; hence, no rating is sought for this tranche.There are restrictions imposed as to what the collateral manager may do and certain tests that must be satisfied for the CDO to maintain the credit rating assigned at the time of issuance.Copyright 2010 Pearson Education, Inc. Publishing as Prentice

9、 Hall16-6Structure of a CDO (continued)The proceeds to meet the obligations to the CDO tranches (interest and principal repayment) can come from:coupon interest payments from the collateral assetsmaturing of collateral assetssale of collateral assetsIn a typical structure, one or more of the tranche

10、s has a floating rate.With the exception of deals backed by bank loans that pay a floating rate, the collateral manager invests in fixed-rate bonds.This creates a problem as the manager pays tranche investors a floating rate while investing in assets with a fixed rate.Copyright 2010 Pearson Educatio

11、n, Inc. Publishing as Prentice Hall16-7Structure of a CDO (continued)Arbitrage Versus Balance Sheet TransactionsCDOs are categorized as either arbitrage transactions or balance sheet transactions.The categorization depends on the motivation of the sponsor of the transaction.In an arbitrage transacti

12、on, the sponsor seeks to earn the spread between the higher yield received on the collateral assets and the lower yield paid to the various tranches in the structure.In a balance sheet transaction, the sponsors motivation is to remove debt instruments from its balance sheet.Copyright 2010 Pearson Ed

13、ucation, Inc. Publishing as Prentice Hall16-8Structure of a CDO (continued)Cash Versus Synthetic StructuresCDOs are also classified in terms of cash CDO structures and synthetic CDO structures.The latter involve the use of credit derivatives.At the outset of this chapter, we will focus on cash CDO s

14、tructures.The last section of this chapter will cover synthetic CDO structures.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-9Arbitrage TransactionsThe key as to whether it is economically feasible to create an arbitrage CDO is whether a structure can offer a competitive retur

15、n for the subordinate/equity tranche.The economics of arbitrage CDO structures show the need for the use of an interest-rate swap, and how the subordinate/equity tranche will realize a return.In determining whether or not to create a CDO, dealers will look to see if there is a potential return avail

16、able to the equity tranche of a minimum amount.The threshold return is based on market conditions.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-10Arbitrage Transactions (continued)Types of Arbitrage TransactionsArbitrage transactions can be divided into two types depending on

17、the primary source of the proceeds from the collateral to satisfy the obligation to the tranches.If the primary source is the interest and maturing principal from the collateral, then the transaction is referred to as a cash flow transaction.If instead the proceeds to meet the obligations depend hea

18、vily on the total return generated from the collateral (i.e., interest e, capital gain, and maturing principal), then the transaction is referred to as a market value transaction.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-11Cash Flow TransactionsTypes of Arbitrage Transacti

19、onsIn a cash flow transaction, the objective of the collateral manager is to generate cash flow for the senior and mezzanine tranches without the need to actively trade bonds.There are three relevant periods.The first is the ramp-up period.This is the period that follows the closing date of the tran

20、saction where the collateral manager begins investing the proceeds from the sale of the debt obligations issued.This period usually lasts from one to two years.The reinvestment period or revolving period is where principal proceeds are reinvestedThis period usually lasts for five or more years.In th

21、e final period, the collateral is sold and the debtholders are paid off.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-12Cash Flow Transactions (continued)Distribution of e e is derived from interest e from the collateral assets and capital appreciation.The e is used as follows

22、.Payments are first made to the trustee and administrators and then to the senior collateral manager.Once these fees are paid, then the senior tranches are paid their interest.At this point, before any other payments are made, certain tests must be passed.These tests are called coverage tests.If the

23、 coverage tests are passed, then interest is paid to the mezzanine tranches.Once the mezzanine tranches are paid, interest is paid to the subordinate/equity tranche.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-13Cash Flow Transactions (continued)Distribution of Principal Cash

24、 FlowThe principal cash flow is distributed as follows after the payment of the fees to the trustees, administrators, and senior managers.If there is a shortfall in interest paid to the senior tranches, principal proceeds are used to make up the shortfall.After all the debt obligations are satisfied

25、 in full, if permissible, the equity investors are paid.Management is permitted to share on some prorated basis once the target return is achieved.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-14Cash Flow Transactions (continued)Restrictions on Management: Quality TestsIn rati

26、ng a transaction, the rating agencies are concerned with the diversity of the assets.Consequently, there are tests that relate to the diversity of the assets and these tests are called quality tests .Quality tests consider:maturity restrictionsrestrictions imposed on the concentration of bonds in ce

27、rtain countries or geographical regions for collateral consisting of emerging market bondsA diversity score is a measure that is constructed to gauge the diversity of the collaterals assets.The greater the score value, the lower the likelihood of default.Copyright 2010 Pearson Education, Inc. Publis

28、hing as Prentice Hall16-15Cash Flow Transactions (continued)Restrictions on Management: Quality TestsOne can describe the distribution of the credit ratings of the collateral in terms of the percentage of the collaterals asset in each credit rating.However, there is a need to have one figure that su

29、mmarizes the rating distribution test.Moodys and Fitch have developed a measure to summarize the rating distribution.This is commonly referred to as the weighted-average rating factor (WARF) for the collateral.Unlike Moodys and Fitch, S&P uses a different system. S&P specifies required rating percen

30、tages that the collateral must maintain.Specifically, S&P requires strict percentage limits for lower rated assets in the collateral.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-16Cash Flow Transactions (continued)Restrictions on Management: Quality TestsThere are two types o

31、f coverage tests to ensure that the performance of the collateral is sufficient to make payments to the various tranches.These two types are called par value tests and interest coverage ratio tests.A separate par value test is used for each rated bond issued in the transaction.A par value test speci

32、fies that the par value of the collateral be at least a specified percentage above the liability to the bondholders.An overcollateralization test for a rated bond issued is a measure of the cushion provided by the collaterals assets over the obligation to the bondholders in terms of par value.Copyri

33、ght 2010 Pearson Education, Inc. Publishing as Prentice Hall16-17Cash Flow Transactions (continued)Restrictions on Management: Quality TestsThe percentage in the par value test is called the trigger, and the trigger is different for each rated bond.Specifically, the trigger declines as the rating de

34、clines.While par value tests focus on the market value of the collateral relative to the par value of the bonds issued, interest coverage tests look at the ability to meet interest payments when due.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-18Market Value TransactionsIn a

35、market value transaction, the cash flow generated to pay the bondholders depends upon the ability of the collateral manager to maintain and improve the market value of the collateral.Funds to be used for liability principal payments are obtained from liquidating the collateral.Liability interest pay

36、ments can be made from collateral interest receipts, as well as collateral liquidation proceeds.Ratings are based on price volatility, liquidity, and market value of the collateral assets.The collateral manager focuses on maximizing total return while minimizing volatility.Copyright 2010 Pearson Edu

37、cation, Inc. Publishing as Prentice Hall16-19Market Value Transactions (continued)The order of priority of the principal payments in the capital structure is as follows.Fees are paid first for trustees, administrators, and managers.After these fees are paid, the senior facility class and the senior

38、notes class are paid.These two classes in the capital structure are treated equally in their rights to their claim on cash proceeds from the collateral.The senior-subordinated notes would be paid, followed by the subordinated notes.All of this assumes that the overcollateralization tests are satisfi

39、ed.If not, the senior notes are then paid down until the overcollateralization tests are brought into compliance.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-20Market Value Transactions (continued)When rating a cash flow transaction, the rating agencies look at the ability of

40、 the collateral to generate sufficient current cash flow to pay interest and principal on rated notes issued by the CDO.The ratings are based on the effect of collateral defaults and recoveries on the receipt of timely interest and principal payments from the collateral.It is the job of the collater

41、al manager to concentrate efforts on controlling defaults and recoveries.If the overcollateralization tests are not met, then cash flow is diverted from the mezzanine and subordinated classes to pay down senior notes, or cash flow is trapped in a reserve account.Failing the overcollateralization tes

42、ts does not force sale of the collateral.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-21Market Value Transactions (continued)Overcollateralization TestsOvercollateralization tests in market value transactions are based on the market value of the collateral, not the par value.

43、Market value overcollateralization tests require that the market value of the collateral be adjusted to obtain an adjusted market value for the collateral.The advance rates are the key in the overcollateralization tests and critical in market value transactions.Advance rates are determined by the ra

44、ting agencies based on a combination of three factors:price volatilitycorrelation among securitiesliquidityCopyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-22Market Value Transactions (continued)Overcollateralization TestsThere is then an advance rate assigned to each asset type

45、based on the structure of the transaction, and the composition of the collateral. For example, suppose that a structure has only one rated tranche. This means that there is only a senior tranche and no mezzanine tranche. Consequently, all of the protection for the senior tranche must come from the c

46、ollateral. The below table shows the advance rates for performing high-yield bonds rated B assigned by Moodys to obtain a target rating of Aaa, Aa3, A3, or Baa3 if the collateral contains one asset type: Target RatingAaaAa3A3Baa320 Issuers and 5 Industries0.720.770.800.8540 Issuers and 10 Industries

47、0.740.800.830.86Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-23Market Value Transactions (continued)Overcollateralization TestsSuppose that the collateral consists of three asset types with the assumed advance ratings for the particular rating sought for a tranche:The market

48、value of the collateral is $100 million. The adjusted market value that must be used in the overcollateralization tests for this tranche would then be found by multiplying the market value of an asset type by the advance rate and then summing over all asset types. So, for our hypothetical collateral

49、, the adjusted market value is found as follows:($50M 0.80) + ($30M 0.75) + ($20M x 0.70) = $76,500,000 Asset TypeMarket ValuePerforming High-Yield Bonds Rated Baa $50 million 0.80Performing High-Yield Bonds Rated B $30 million 0.75Performing High-Yield Bonds Valued Below Caa $20 million 0.70Advance

50、 RateCopyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-24Synthetic CDOsCash CDO structures are so named because the collateral assets are owned.In recent years, the fastest growing sector of the CDO market is the synthetic CDO structure.The name follows from the fact that the coll

51、ateral assets are not actually owned.In a synthetic CDO the collateral absorbs the economic risks associated with specified assets but does not have legal ownership of those assets.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-25Synthetic CDOs (continued)The creation of a synt

52、hetic CDO structure requires the use of a credit derivative.More specifically, the type of credit derivative used is a credit default swap.A credit default swap allows market participants that own an asset to transfer the credit risk associated with that asset to another party without transferring t

53、he legal ownership of that asset.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-26Synthetic CDOs (continued)For a credit default swap, there is a credit protection buyer and a credit protection seller.The credit protection buyer pays a fee (premium) to the credit protection sel

54、ler.If a “credit event” occurs, then the credit protection seller must make a payment to the credit protection buyer.Credit events on a debt instrument may include bankruptcy, failure to pay when due, downgrading of an issue, debt repudiation, and debt restructuring.Copyright 2010 Pearson Education,

55、 Inc. Publishing as Prentice Hall16-27Synthetic CDOs (continued)With basic information about credit default swaps, we can look at the basic structure of a synthetic CDO.As with a cash CDO structure, liabilities are issued.The proceeds received from the tranches will be invested by the collateral man

56、ager in assets with low risk.In addition, the collateral manager will enter into a credit default swap with another entity in which it will provide credit protection.Because it is selling credit protection, the collateral manager will receive the credit default swap fee.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall16-28Synthetic CDOs (cont