Chapter 20 Collateralized Debt Obligations

Laurie S. Goodman, Ph.D.

Managing Director UBS Warburg

Frank J. Fabozzi, Ph.D., CFA

Adjunct Professor of Finance School of Management Yale University

Acollateralized debt obligation (CDO) is an asset-backed security backed by a diversified pool of one or more of the following types of debt obligations:

  • U.S. domestic investment-grade and high-yield corporate bonds
  • U.S. domestic bank loans
  • emerging market bonds
  • special situation loans and distressed debt
  • foreign bank loans
  • asset-backed securities
  • residential and commercial mortgage-backed securities

When the underlying pool of debt obligations consists of bond-type instruments (corporate and emerging market bonds), a CDO is referred to as a collateralized bond obligation (CBO). When the underlying pool of debt obligations are bank loans, a CDO is referred to as a collateralized loan obligation (CLO).

In this chapter we explain the basic CDO structure, the types of CDOs, the risks associated with investing in CDOs, and the general principles for creating a portfolio of CDOs.

STRUCTURE OF A CDO

In a CDO structure, there is an asset manager responsible for managing the portfolio. There are restrictions imposed (i.e., restrictive covenants) as to what the asset manager may do and certain tests that must be satisfied for the CDO securities to maintain the credit rating assigned at the time of issuance. We’ll discuss some of these requirements later.

The funds to purchase the underlying ...

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