Lesson 5 of 6 · 13 min
CDOs: managed pools and leveraged equity
A CDO is a securitization of a diversified, actively managed pool of debt; its equity holders are effectively borrowing from the debt tranches and earn the gap between what the collateral yields and what the tranches cost.
In short
- Collateralized debt obligation (CDO): securities backed by a diversified pool of one or more debt obligations.
- Types by collateral: CBO (corporate and emerging-market bonds), CLO (leveraged bank loans), structured finance CDO (other CDOs), synthetic CDO (credit default swaps). The CLO is now the dominant form.
- Most CDO pools are not static, so a collateral manager buys and sells debt to generate enough cash for the bondholders.
- Cash to pay tranches comes from interest, maturing collateral and sales of collateral.
- A CDO is a leveraged transaction: debt tranches earn fixed returns; the equity tranche and the manager earn equity-like returns from the spread between collateral return and funding cost.
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