Synthetic Collateralized Debt Obligation
Synthetic Collateralized Debt Obligation (Synthetic CDOs) that have become increasingly popular were first created in the late 1990s as a way for large holders of commercial loans to protect their balance sheets without actually selling the loans and potentially harming client relationships.
Collateralized Debt Obligation (CDO) is an investment-grade security backed by a pool of
bonds, loans and other assets. CDOs do not specialize in one type of debt but are often non-mortgage loans or bonds.
Synthetic Collateralized Debt Obligation (Synthetic CDOs) is a form of collateralized debt obligation (CDO) that invests in
credit default swaps (CDSs) or other non-cash assets to gain exposure to a portfolio of fixed income assets. Therefore, a synthetic CDO didn't contain any actual bonds. It allowed an entity such as hedge fund firm to buy insurance on security, such as bonds, it didn't own. If the bonds performed well, the buyer would make a steady stream of small payments, much like insurance premiums. If they performed poorly, the buyer would receive potentially large payouts.
Synthetic CDOs are typically divided into credit tranches based on the level of credit risk assumed. Initial investments into the CDO are made by the lower tranches, while the senior tranches may not have to make an initial investment.
All tranches will receive periodic payments based on the cash flows from the credit default swaps. If a credit event occurs in the fixed income portfolio, the synthetic CDO and its investors become responsible for the losses, starting from the lowest rated tranches and working its way up.
Synthetic CDOs offer extremely high yields to investors, but investors can be on the hook for much more than their initial investments if several credit events occur in the reference portfolio.
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