Structured Products and Related Credit Derivatives: A Comprehensive Guide for Investors

CHAPTER 13

CDO Equity

Brian McManus

Senior CDO Analyst

Wachovia Capital Markets, LLC

Steven Todd, Ph.D.

CDO Analyst

Wachovia Capital Markets, LLC

Anik Ray

Associate CDO Analyst

Wachovia Capital Markets, LLC

Dave Preston, CFA

Associate CDO Analyst

Wachovia Capital Markets, LLC

The equity of a collateralized debt obligation (CDO) represents a residual claim on the cash flows from the assets collateralizing a CDO. By providing access to assets that investors cannot easily gain exposure to, CDOs deliver diversification benefits that expand the efficient frontier. Although CDO equity returns are closely linked to the performance of the underlying assets, returns will not be perfectly correlated due to structural provisions that affect the way collateral cash flows are distributed.

CDO equity investors can earn high dividend payments that are typically front-loaded. Moreover, compared with private equity and hedge fund investments, CDO equity offers greater transparency. Like the former, CDO equity is also risky and illiquid and investors could lose part of their original investment. We recommend investors thoroughly understand this product before investing.

We believe CDO equity investors should stress-test issues using vector analysis. By using vector analysis, investors can determine how equity will perform if defaults are front-loaded (worst case) or back-loaded (best case). Potential buyers often request CDO equity performance statistics, but these are not easily summarized due ...