Explain collateralized debt obligations, the cash flows they generate and the risks involved
The idea
A collateralised debt obligation is a structured security backed by a diversified pool of debt obligations, such as corporate bonds or, in a collateralised loan obligation, leveraged loans. A collateral manager buys and manages the pool, funding it by issuing tranches: senior, mezzanine and an equity or residual tranche. Interest from the collateral pays the senior and mezzanine tranches at their coupons and any fees, and whatever remains goes to the equity holders, so the structure only works when the collateral yields more than the cost of funding it. Losses run the other way, falling first on equity, then mezzanine, then senior. A synthetic CDO takes credit exposure through credit default swaps rather than owning the bonds. The key risks are default losses, the manager's skill, and default correlation: if defaults cluster more than assumed, even senior tranches can suffer.
A practice question
The collateral in a collateralised loan obligation (CLO) is typically a pool of:
- leveraged loans — correct
- residential mortgagesWhy not: That is the collateral for residential MBS, not a CLO.
- government bondsWhy not: Government bonds offer too little spread to fund a CDO's tranches.
A CLO is a CDO backed by leveraged loans, bought and managed by a collateral manager and funded by issuing tranches.
A harder one
A CDO holds 200 million of collateral yielding 9%. It issues 140 million of senior notes at 6% and 40 million of mezzanine at 8%, with 20 million of equity. Fees are 0.4 million a year. With no defaults, the annual return to equity is:
- 32.0%Why not: Leaves out the 0.4 million of fees paid ahead of the equity holders.
- 3.0%Why not: Divides the residual cash by all the collateral instead of by the 20 million of equity.
- 30.0% — correct
Interest = 18.0m. Senior = 8.4m; mezzanine = 3.2m; fees = 0.4m. Residual = 18.0 - 12.0 = 6.0m, or 6.0 / 20 = 30.0% on equity.
The hardest tier
A CDO funded by a 140 million senior tranche, a 40 million mezzanine tranche and 20 million of equity suffers principal losses of 30 million on its collateral. The mezzanine tranche loses:
- 6 millionWhy not: Spreads the loss pro rata by size (40/200 x 30). Losses follow the order of subordination.
- 10 million — correct
- 30 millionWhy not: Reverses the order, putting mezzanine ahead of equity to absorb losses.
Equity absorbs the first 20 million and is wiped out; the next 10 million falls on the mezzanine tranche; the senior tranche is untouched.
In the app: 6 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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