1、Chapter 16 Collaterized Debt Obligations Learning ObjectivesAfter reading this chapter, you will understandwhat is meant by a collateralized debt obligation, collateralized bond obligation, and collateralized loan obligationthe structure of a collateralized debt obligation and the role of the collat
2、eral managerthe difference between an arbitrage and balance sheet transactionthe economics underlying an arbitrage transactionthe motivation for a balance sheet transactionLearning Objectives (continued)After reading this chapter, you will understandthe difference between a cash flow transaction and
3、 a market value transactionthe types of restrictions imposed on management in a collateralized 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 transactionStructure of a CDO
4、In a collateralized bond 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 coll
5、ateral are referred to as 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
6、not have a mezzanine tranche.Structure 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 flow; hence, no rating is sought for this
7、 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.Structure of a CDO (continued) The proceeds to meet the obligations to the CDO tranches (interest and
8、principal repayment) can come from:i.coupon interest payments from the collateral assetsii. maturing of collateral assetsiii. sale of collateral assets In a typical structure, one or more of the tranches has a floating rate. With the exception of deals backed by bank loans that pay a floating rate,
9、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.Structure of a CDO (continued) Arbitrage Versus Balance Sheet Transactions CDOs are categorized as either arbitrage transaction
10、s or balance sheet transactions. The categorization depends on the motivation of the sponsor of the transaction. In an arbitrage transaction, 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 struct
11、ure. In a balance sheet transaction, the sponsors motivation is to remove debt instruments from its balance sheet.Structure of a CDO (continued) Cash Versus Synthetic Structures CDOs are also classified in terms of cash CDO structures and synthetic CDO structures.o The latter involve the use of cred
12、it derivatives. At the outset of this chapter, we will focus on cash CDO structures. The last section of this chapter will cover synthetic CDO structures.Arbitrage Transactions The key as to whether it is economically feasible to create an arbitrage CDO is whether a structure can offer a competitive
13、 return 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 retu
14、rn available to the equity tranche of a minimum amount. The threshold return is based on market conditions.Arbitrage Transactions (continued) Types of Arbitrage Transactions Arbitrage transactions can be divided into two types depending on the primary source of the proceeds from the collateral to sa
15、tisfy the obligation to the tranches.i.If the primary source is the interest and maturing principal from the collateral, then the transaction is referred to as a cash flow transaction.ii.If instead the proceeds to meet the obligations depend heavily on the total return generated from the collateral
16、(i.e., interest income, capital gain, and maturing principal), then the transaction is referred to as a market value transaction.Cash Flow Transactions Types of Arbitrage TransactionsIn a cash flow transaction, the objective of the collateral manager is to generate cash flow for the senior and mezza
17、nine tranches without the need to actively trade bonds.There are three relevant periods.i.The first is the ramp-up period.oThis is the period that follows the closing date of the transaction where the collateral manager begins investing the proceeds from the sale of the debt obligations issued.oThis
18、 period usually lasts from one to two years.ii.The reinvestment period or revolving period is where principal proceeds are reinvestedoThis period usually lasts for five or more years.iii. In the final period, the collateral is sold and the debtholders are paid off.Cash Flow Transactions (continued)
19、Distribution of IncomeIncome is derived from interest income from the collateral assets and capital appreciation.The income is used as follows.oPayments are first made to the trustee and administrators and then to the senior collateral manager.oOnce these fees are paid, then the senior tranches are
20、paid their interest.oAt this point, before any other payments are made, certain tests must be passed.oThese tests are called coverage tests.If the coverage tests are passed, then interest is paid to the mezzanine tranches.Once the mezzanine tranches are paid, interest is paid to the subordinate/equi
21、ty tranche.Cash Flow Transactions (continued) Distribution of Principal Cash Flow The principal cash flow is distributed as follows after the payment of the fees to the trustees, administrators, and senior managers.i.If there is a shortfall in interest paid to the senior tranches, principal proceeds
22、 are used to make up the shortfall.ii. After all the debt obligations are satisfied in full, if permissible, the equity investors are paid.iii. Management is permitted to share on some prorated basis once the target return is achieved.Cash Flow Transactions (continued) Restrictions on Management: Qu
23、ality Tests In rating 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:i.maturity restrictionsii.restrictions imposed on the co
24、ncentration of bonds in certain countries or geographical regions for collateral consisting of emerging market bonds A diversity score is a measure that is constructed to gauge the diversity of the collaterals assets.oThe greater the score value, the lower the likelihood of default.Cash Flow Transac
25、tions (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 summarizes the rating distribution test.Mood
26、ys 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 percentages that the collateral must maintain.Sp
27、ecifically, S&P requires strict percentage limits for lower rated assets in the collateral.Cash Flow Transactions (continued) Restrictions on Management: Quality TestsThere are two types of coverage tests to ensure that the performance of the collateral is sufficient to make payments to the various
28、tranches.These two types are called par value tests and interest coverage ratio tests.oA separate par value test is used for each rated bond issued in the transaction.oA par value test specifies that the par value of the collateral be at least a specified percentage above the liability to the bondho
29、lders.oAn 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.Cash Flow Transactions (continued) Restrictions on Management: Quality Tests The percentage in the par value test i
30、s called the trigger, and the trigger is different for each rated bond.o Specifically, the trigger declines as the rating declines. 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 int
31、erest payments when due.Market Value Transactions In a 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 obtaine
32、d from liquidating the collateral. Liability interest payments 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 re
33、turn while minimizing volatility.Market Value Transactions (continued) The order of priority of the principal payments in the capital structure is as follows.i.Fees are paid first for trustees, administrators, and managers.ii.After these fees are paid, the senior facility class and the senior notes
34、class are paid.oThese two classes in the capital structure are treated equally in their rights to their claim on cash proceeds from the collateral.iii. The senior-subordinated notes would be paid, followed by the subordinated notes.All of this assumes that the overcollateralization tests are satisfi
35、ed.If not, the senior notes are then paid down until the overcollateralization tests are brought into compliance.Market Value Transactions (continued) When rating a cash flow transaction, the rating agencies look at the ability of the collateral to generate sufficient current cash flow to pay intere
36、st 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 collateral manager to concentrate efforts on controlling defaults and recoveri
37、es.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 tests does not force sale of the collateral.Market Value Transactions (co
38、ntinued) Overcollateralization Tests Overcollateralization tests in market value transactions are based on the market value of the collateral, not the par value.oMarket value overcollateralization tests require that the market value of the collateral be adjusted to obtain an adjusted market value fo
39、r the collateral. The advance rates are the key in the overcollateralization tests and critical in market value transactions.oAdvance rates are determined by the rating agencies based on a combination of three factors:i.price volatilityii.correlation among securitiesiii. liquidityMarket Value Transa
40、ctions (continued) Overcollateralization TestsThere is then an advance rate assigned to each asset type 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 a
41、nd no mezzanine tranche. Consequently, all of the protection for the senior tranche must come from the collateral. 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 asse
42、t type: Target RatingAaaAa3A3Baa320 Issuers and 5 Industries0.720.770.800.8540 Issuers and 10 Industries0.740.800.830.86Market Value Transactions (continued) Overcollateralization TestsSuppose that the collateral consists of three asset types with the assumed advance ratings for the particular ratin
43、g sought for a tranche:The market 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. S
44、o, for our hypothetical collateral, 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
45、 Below Caa $20 million 0.70Advance RateSynthetic CDOs Cash 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 collateral assets are not actually own
46、ed. In a synthetic CDO the collateral absorbs the economic risks associated with specified assets but does not have legal ownership of those assets.Synthetic CDOs (continued) The creation of a synthetic CDO structure requires the use of a credit derivative. More specifically, the type of credit deri
47、vative 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 the legal ownership of that asset.Synthetic CDOs (continued) For a credit default swap, there is a cre
48、dit protection buyer and a credit protection seller. The credit protection buyer pays a fee (premium) to the credit protection seller. 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 bank
49、ruptcy, failure to pay when due, downgrading of an issue, debt repudiation, and debt restructuring.Synthetic 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 r
50、eceived from the tranches will be invested by the collateral manager 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
