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 collatera
2、l 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 a ma
3、rket 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(conti
4、nued)The proceeds to meet the obligations to the CDO tranches(interest and principal repayment)can come from:coupon interest payments from the collateral assetsmaturing of collateral assetssale of collateral assets In a typical structure,one or more of the tranches has a floating rate.With the excep
5、tion of deals backed by bank loans that pay a floating rate,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 Transact
6、ions CDOs are categorized as either arbitrage transactions 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
7、lower yield paid to the various tranches in the structure.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 C
8、DO structures.o The latter involve the use of credit 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
9、 is whether a structure can offer a competitive 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 wi
10、ll look to see if there is a potential return 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 o
11、f the proceeds from the collateral to satisfy the obligation to the tranches.If the primary source is the interest and maturing principal from the collateral,then the transaction is referred to as a cash flow transaction.If instead the proceeds to meet the obligations depend heavily on the total ret
12、urn generated from the collateral(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 f
13、low for the senior and mezzanine tranches without the need to actively trade bonds.There are three relevant periods.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 deb
14、t obligations issued.oThis period usually lasts from one to two years.The reinvestment period or revolving period is where principal proceeds are reinvestedoThis period usually lasts for five or more years.In the final period,the collateral is sold and the debtholders are paid off.Cash Flow Transact
15、ions(continued)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
16、 tranches are 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 subord
17、inate/equity 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.If there is a shortfall in interest paid to the senior tranches,principal proce
18、eds are used to make up the shortfall.After all the debt obligations are satisfied in full,if permissible,the equity investors are paid.Management is permitted to share on some prorated basis once the target return is achieved.Cash Flow Transactions(continued)Restrictions on Management:Quality Tests
19、 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:maturity restrictionsrestrictions imposed on the concentration of bonds
20、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 Transactions(continued)Restri
21、ctions 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.Moodys and Fitch have develope
22、d 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.Specifically,S&P requires strict
23、 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 tranches.These two types are calle
24、d 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 bondholders.oAn overcollateralization te
25、st 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 is called the trigger,and the trigger
26、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 interest payments when due.Market Value Tran
27、sactions 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 obtained from liquidating the collateral.Liability
28、 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 return while minimizing volatility.Market Value Tra
29、nsactions(continued)The order of priority of the principal payments in the capital structure is as follows.Fees are paid first for trustees,administrators,and managers.After these fees are paid,the senior facility class and the senior notes class are paid.oThese two classes in the capital structure
30、are treated equally in their rights to their claim on cash proceeds from the collateral.The senior-subordinated notes would be paid,followed by the subordinated notes.All of this assumes that the overcollateralization tests are satisfied.If not,the senior notes are then paid down until the overcolla
31、teralization 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 interest and principal on rated notes issued by the CDO.The ratings are bas
32、ed 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 recoveries.If the overcollateralization tests are not met,then cash flow is d
33、iverted 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(continued)Overcollateralization Tests Overcollateralization tests in marke
34、t 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 for the collateral.The advance rates are the key in the overcollateralizatio
35、n tests and critical in market value transactions.oAdvance rates are determined by the rating agencies based on a combination of three factors:price volatilitycorrelation among securitiesliquidityMarket Value Transactions(continued)Overcollateralization TestsThere is then an advance rate assigned to
36、 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 and no mezzanine tranche.Consequently,all of the protection for the senior tranche must come
37、 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 asset type:Target RatingAaaAa3A3Baa320 Issuers and 5 Industries0.720.770.800.8540 Issuers and 10 Indu
38、stries0.740.800.830.86Market Value Transactions(continued)Overcollateralization TestsSuppose that the collateral consists of three asset types with the assumed advance ratings for the particular rating sought for a tranche:The market value of the collateral is$100 million.The adjusted market value t
39、hat 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.So,for our hypothetical collateral,the adjusted market value is found as follows:($50M 0.80)+($30M 0.75)
40、+($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 Below Caa$20 million 0.70Advance RateSynthetic CDOs Cash CDO structures are so named because the collateral asse
41、ts 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 owned.In a synthetic CDO the collateral absorbs the economic risks associated with specified assets but does not have le
42、gal 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 derivative used is a credit default swap.A credit default swap allows market participants that own an asset to transfer the cr
43、edit 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 credit protection buyer and a credit protection seller.The credit protection buyer pays a fee(premium)to the credit protection se
44、ller.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 bankruptcy,failure to pay when due,downgrading of an issue,debt repudiation,and debt restructuring.Synthetic CDOs(continued)With basic inf
45、ormation 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 received from the tranches will be invested by the collateral manager in assets with low risk.In addition,the collateral manager will enter into
46、a credit default swap with another entity in which it will provide credit protection.Because it is selling credit protection,the collateral manager will receive the credit default swap fee.Synthetic CDOs(continued)On the other side of the credit default swap will be a credit protection buyer who wil
47、l be paying the fee.This entity will be a financial institution seeking to shed the credit risk of some of its assets.For example,it could be a bank that is using the credit default swap for some specifically defined loans in the banks portfolio.These loans are referred to as the reference assets in
48、 the credit default swap.Synthetic CDOs(continued)If a credit event does not occur,the return realized by the collateral manager that will be available to meet the structures obligations will be the return on the collateral consisting of low risk assets plus the fee received from the credit default
49、swap.If there is a default on any of the referenced assets,the collateral manager must make a payment to the counterparty.This reduces the return available to meet the structures obligations.Synthetic CDOs(continued)There are structures that include elements of both cash flow and synthetic transacti
50、ons.That is,with the proceeds obtained from the sale of the bond classes,the collateral manageruses a portion to purchase for the portfolio bonds and/or loans(as in a cash flow transaction)invests the balance in high-quality debt instruments(as in a synthetic transaction)sells credit protection on s
