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SPV (Special Purpose Vehicle) is an independent entity that invests in asset portfolios. The asset classes typically invested in CDOs (Collateralized Debt Obligations) include corporate debt (such as loans or bonds) but are not limited to this. To raise funds for investing in the asset portfolio, the SPV borrows money by issuing bonds to investors. The investors who purchase the bonds will receive repayment when the assets mature. The investors bear the default risk of the asset portfolio. Still, since the bonds are divided into several levels of repayment priority, the risks borne by different investors are not the same. These bonds are usually sold to institutional investors, but retail investors increasingly buy them.
Q: Are CDOs similar to mutual funds?
A: No. All investors share the risks and returns of mutual funds. CDO transactions are composed of bonds of different levels, each with different risks and returns. If any asset in the underlying asset pool defaults, the lowest level bond (usually called the equity tranche of the CDO) will bear the losses first. As losses in the asset pool increase, other levels of bonds may also be affected. Investors who invest in the same level of CDO bonds share the losses on average.
Q: What happens if a company defaults in the previous example?
A: In case of default, it may result in insufficient funds to repay each investor (see point 6). If a default occurs, A, B, and C-level bonds will still receive full repayment, but the D-level bond, which initially had a principal of $5 million, may lose up to $1 million.
Q: Will investors in the D-level bond always incur losses in the previous example?
A: Not necessarily. It depends on whether any default occurs among the 20 companies that issued the bonds.
Q: How much money will D-level bond investors lose if a default occurs?
A: It depends on the situation and must be determined based on the potential recovery level of the defaulted assets. In the worst-case scenario, where no recovery is possible, the entire $1 million will be lost due to default.
Q: Will A, B, and C-level bonds incur losses in the previous example?
A: Yes, it depends on the severity of the defaults in the asset pool. Assuming no recovery is possible for all defaults, the D-level bond will incur losses after five defaults, and the C-level bond will incur losses when the sixth default occurs.
Q: What are the main risks of CDO transactions?
A: As mentioned above, the principal risks of CDO transactions come from credit risks associated with the asset pool companies. When investors invest in an asset pool composed of bonds or loans from different companies, they essentially lend money indirectly to these companies and become their creditors. If any of these companies default, creditors risk being unable to recover the borrowed funds. CDO transactions also face risks like uncertain recovery levels, law changes, and document risks. Asset pools that are actively managed may also face risks associated with the management actions of the collateral manager. A small category of CDO transactions faces not credit risk (see question 41) but rather periodic changes in the market value of loans or bonds. These types of CDO transactions are known as market-value CDOs. Investors should read the prospectus or investment memorandum to understand the transaction details and related risks.
Q: How does the recovery rate of defaulting bonds affect the risk of the transaction?
A: The level of losses incurred by investors depends not only on the expected default rate but also on the expected recovery rate in the event of default.
Q: What other factors affect the recovery rate of defaulting bonds?
A: Other factors that affect the recovery rate include the laws of the country where the bond issuer is located, whether the issuer enters into bankruptcy legal proceedings, and the method of recovery adopted by the CDO from the defaulted debt. The recovery method may differ if the assets of the CDO are still held and can be disposed of during the bankruptcy process or if the assets can be sold or agreements can be reached quickly after the company defaults.
Q: Does investing only in senior secured bonds in a CDO imply a lower likelihood of default by the issuer?
A: No. The seniority and security of the debt held by a CDO do not affect any company’s default likelihood. However, the seniority and security of the debt held by the CDO can affect the expected recovery level after the company defaults, as higher-rated debts are expected to have higher recovery levels.
Q: Can you make CDO transactions with other types of CDOs?
A: The CDO structures discussed above are commonly referred to as cash flow CDOs, as the funds collected by the SPV from investors are used to purchase assets, and the cash flows generated by these assets are used to repay investors.
Q: How are CDOs typically classified?
A: CDOs are classified based on structure, collateralized transaction restrictions, and trading motivations. The structures of CDOs can be classified into the following types:
- Cash Flow: The invested amount is used to purchase assets with remaining balances sufficient to repay the investors. The principal and interest to investors are paid from the cash flows generated by these assets.
- Synthetic: The covered assets are designated through credit default swap contracts. An SPV holds the amount invested by investors. If the designated assets default, the SPV will pay the loss amount to the counterparty, which will reduce the amount to be returned to investors by the SPV in the future.
- Hybrid: The transaction may include the purchase of assets and credit default swap contracts.
- Market Value: The amount invested by investors is used to purchase assets. These assets’ market values will be monitored, and if the market values decline, these assets will be sold to repay investors.
Q: What are the options for collateralized transactions in CDOs?
A: The options for collateralized transactions in CDOs include:
- Static: The assets in the asset pool remain unchanged.
- Managed: The asset pool is monitored by a manager who has the authority to sell any assets in the pool.
