Collateralised Debt Obligation or CDOs are normally floating rate structured debt securities that pay a higher return compared to similarly rated securities in exchange for a higher risk profile. They are complex, structured products typically arranged by investment banks with a range of tranches that are independently rated by credit rating agencies. The performance of an investment in a CDO security is linked to the credit risk of an underlying portfolio of company debt or other securities. The exposure to this portfolio is leveraged, the degree of which is determined by the subordination of the investment in the structure of the CDO amongst other things; the tenor of CDO securities typically ranges from three to seven years. If only a few of the underlying portfolio of securities default over the life of the CDO, investors will receive their capital back in full. If more than a handful default, investor’s capital may be at risk. The more companies that default, the greater the probability of investors losing capital. Synthetic CDOs reference a portfolio of credit default swaps (i.e. synthetic credit exposure) as opposed to investing in corporate bonds. Instead of acquiring the physical portfolio of assets, credit default swaps are used to create a synthetic portfolio of assets and the investors” cash is “parked” in highly rated (typically AAA rated) collateral.
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