Investment Strategies of Hedge Funds

8

Strategies on CDOs

A Collateralized Debt Obligation (CDO) is a diversified set of similar financial instruments where credit risk is allocated differently among the various tranches making up the CDO. It gives investors exposure to a customized slice (tranche) of the credit risk of a selected portfolio of reference credits.

Many different financial assets can be used to collateralize a CDO: asset-backed securities (ABS), corporate bonds, bank loans, emerging markets bonds, credit default swaps, etc.

The CDO market has reached a size of $583 billion (Figure 8.1), representing 15 % of the ABS market. According to some observers, the CDO market is still at its infancy and gives rise to many investment opportunities for the more experienced fund managers.

In more detail, a Collateralized Debt Obligation is a basket of bonds or Credit Default Swaps that is cut in different tranches and then sold to investors. Every tranche has a different credit rating and pays a different interest rate. The senior tranche, which has claims to cash flow generated by the underlying securities, has a credit rating of AAA. This is followed by the mezzanine tranche and the equity tranche (completely different from an equity!), which absorbs the eventual losses caused by a default of the underlying securities and receives payments only after all the other tranches have been paid.

In Figure 8.2, the cash flows generated by the pool of securities backing the CDO are portrayed using “Le Jet d’eau de Genève”, ...