FAQsThe main reason is that CDO bonds pay a higher return than similarly rated ordinary bonds. CDOs also allow investors access to asset classes that would otherwise be unavailable directly to them. Investors can choose the level of risk and return that suits their exact requirements by investing in the different bonds issued by a CDO. Finally, CDOs offer ultimate flexibility in terms of currency, risk hedging, maturity etc and can be tailored to investors’ individual requirements.
Cashflow CDOs are based on a diversified pool of assets that produce income. As long as these assets continue to perform the CDO will work. Only if the pool suffers defaults will the CDO lose income and capital to repay the CDO bonds. This leads to the two main reasons why CDOs can offer a higher return:
The underlying assets offer a yield to compensate investors not only for the possibility of default but also for the liquidity of the asset and the possible price volatility. A CDO bond, a buy and hold investment, only requires compensation for the default risk. This leaves excess yield for investors.
CDO bonds are targeted at specific investor types. This means that holders of one class of bond will often subsidise other bond holders.
CDOs are either static or managed. Static CDOs are based on pools of assets which, once purchased, do not change, hence the name. Most static portfolios are arranged purely through investment banks. The alternative is a managed CDOs that pays an asset manager to actively reduce defaults in the underlying portfolio and maximise returns for investors.
Synthetic CDOs reference CDS contracts rather than cash assets but can also be static or managed.
It depends on what the investor requires as the individual types of CDOs have different characteristics. For example, cash CDOs are less flexible than synthetic structures but have slightly more predictable performance. On the other hand, synthetic CDOs are very flexible, in that they enable investors to structure the CDO to their specific risk/return requirements using synthetic assets. The trade-off for investors for this flexibility however is a more complex and less transparent structure.
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