CDO: Alternative Assets Being Used as Underlying Assets

CDOs were created to use bonds, mortgages and commercial loans as the underlying collateral.  In the last ten years, they have begun to use alternative assets such as distressed debt, hedge funds, commodities and private equity as the underlying.  They have also created CDOs with one tranche.

Distressed debt is defined as securities of companies in default or that are trading below investment grade.  They have a yield of the Treasury rate plus 10%.  The portfolio of the CDO may include both distressed and not distressed debt.  By the structure of the CDO, the rating of the senior tranche is higher than the underlying portfolio.  Investors can gain access to distressed debt and limit their risk.  Banks are the main sellers of distressed debt to CDOs.  It cuts their losses on the debt, offloads their liabilities to the CDOs and frees up reserve capital by reducing their nonperforming assets ratio.

Collateralized fund obligations (CFOs) have multiple hedge funds as the underlying assets.  The institutional investors interested in this vehicle are pension funds, insurance companies, mutual funds and high net worth clients.  The hedge funds are aggregated under a fund of fund manager.  The manager has restrictions on the total number of hedge funds, number of investment strategies and percentage invested in each fund.  The restrictions are set by the rating agency.  When the payments are due to the investors of the CFOs, the fund of fund manager has to notify the hedge fund managers to redeem the investments.

Commodities can be the underlying assets for collateralized commodity obligations (CCOs).  More accurately, the assets are Commodities Trigger Swaps (CTSs).  These transactions trigger a payment when a condition is met.  An example would be when the price of the commodity hits a price target.  The CTSs would be based on a basket of commodities.  They would avoid extremely volatile assets.  The trigger events would have to be substantially spread out to avoid multiple payouts at the same time.

Unlike normal CDOs, single tranche CDOs (STCDOs), also known as bespoke CDOs or CDOs on demand, only create one tranche.  They are structured as synthetic CDOs, using CDSs to receive premiums to pay the interest rate on the CDOs' securities.  In this security, the investors have more control over the terms than in a CDO with multiple tranches and receive all cash flows.  The advantage for the sellers is that they are cheaper and quicker to issue.  In a normal CDO, the entire risk of the portfolio is transferred to the investors.  In a STCDOs, only a specific portion of the portfolio risk is transferred to the investors.  The seller is still exposed to the underlying assets in this case.

CDO squared invests in other CDOs.  This allows for more diversification and higher spread returns for the investor.  Losses are incurred based on where (the tranche) bond defaults occur.  In a normal CDO, losses are incurred based on the number of bond defaults.  CDO squared may be cash backed or synthetically created and may invest in different tranches or specialize in one tranche across multiple CDOs.  There is a danger that the CDO squared may invest in assets that are in multiple CDOs.  Rather than diversifying the portfolio, these overlapping assets cause the portfolio to be concentrated in them.  This would cause greater losses than expected if the underlying assets default.

Lastly, there also was a CDO created with private equity investments as the underlying assets.  As with CFOs, there were restrictions on the total number of private equity managers.