Collateralized Debt Obligations: Structures and Analysis, Second Edition

CHAPTER 18

Why Buy CDO Equity?

Our four reasons for buying CDO equity are:

1. The nonrecourse term financing that CDOs provide to CDO equity is very beneficial to the equity holders.
2. The cash flow CDO structure is very forgiving to CDO equity holders, providing significant return even when CDO debt holders are destined to receive less than their due.
3. CDO equity holders receive two valuable options that further increase the value of their investment. Basically, these options are to “sell out early” or “wait and see.”
4. CDO equity can be used as a defensive investment strategy for those investors who are unsure of future economic conditions.

In this chapter, we discuss these reasons for buying CDO equity.

NONRECOURSE TERM FINANCING

CDOs do not just provide financing to CDO equity holders. They deliver nonrecourse term financing because CDO equity holders own stock in a company and are not liable for the losses of that company. CDOs provide “term financing” because the financing rate does not change, the financing cannot be withdrawn, and a cash flow CDO cannot be forced to liquidate its assets.

CDO equity is a leveraged position in the assets of a CDO, with the CDO's debt tranches providing the financing for equity holders. CDO equity receives whatever cash flow remains after satisfaction of debt claims. Equity sustains the risk of collateral asset payment delays and credit losses, but also receives the upside if CDO assets generate cash flow in excess of debt tranche requirements. ...