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Glossary

CDO

Category — Bond Types
Collateralized Debt Obligations (CDOs) are securities collateralized by a diversified pool of assets represented by one or more types of debt obligation. The pool of assets underlying the CDOs can include any instruments that carry the borrower’s credit risk: bonds, loans issued, tranches of securities issued under securitization, credit default swaps, etc.

Depending on the type of underlying asset, there are several types of CDOs:

• Collateralized bond obligation (CBO) means the obligations secured by bonds;
• Collateralized loan obligation (CLO) means the obligations secured by loans;
• Collateralized mortgage obligation (CMO) means the obligations secured by mortgage loans.

There are also synthetic CDOs that carry economic risks for assets, but do not grant the right to own them.

Features:

• This is a derivative financial instrument (derivative);
• It acts as a securitization instrument;
• They are placed in tranches, which in the classic case are divided into senior ones with the highest rating, medium ones with a lower rating, and subordinated ones that are not assigned a rating;
• Coupon payments vary depending on the tranche: the higher is the risk of default, i.e. the lower is the tranche, the higher is the coupon rate for its holder;
•A Manager or CDO manager is responsible for managing the portfolio and maintaining the credit rating;

Advantages:

• For investors and speculators: the opportunity to get arbitrage or speculative profit, respectively;
• For banks: reducing the level of credit risk; increasing liquidity; meeting the capital adequacy requirement; reducing the cost of borrowing; increasing the profitability of banking operations, and, consequently, generating additional profit.

Disadvantages for investors:

• It may contain high-risk assets while having the highest AAA credit rating.
• The high yield compared to other debt instruments of the same credit quality may be due to the presence of risky assets in the CDO, payments for which are higher due to high risk.
• Investors assume the risks of non-fulfilment by borrowers of debt obligations that secure CDOs.

The collapse of the CDO pyramid in the US real estate market was one of the causes of the 2008 financial crisis.

In the case of classical securitisation of assets, the issuer of securities is a SPV (Special Purpose Vehicle) (for example, 2014 Popolare Bari SME SrL), when performing synthetic securitisation, the issuer is the original bank itself (for example, AU Small Finance Bank Limited).
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