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Colateralized securities
COLLATERALIZED SECURITIES
Collateralized securities are all very much the same investment by concept the only difference is that the underlying collateral changes. Of course, as it does the name of the investment changes – Collateralized ___ Obligation.
Underlying collateral Name
Mortgages CMO
Investment Grade Bonds CBO
High Yield Bonds (Debt) CDO
Other Assets (credit card, leases, etc) CIO
Bank Loans CLO
In concept they are very simple. An entity is formed (LLC), that entity takes in some equity and issues debt (C__O’s). With the equity and proceeds it buys the underlying asset of mortgages or bonds or loans or whatever. Since the issued bonds are overcapitalized – there is the equity and a small tranche of subordinated bonds issued, they are rated AAA by the rating agencies and pay AAA yields. Because the underlying asset investments are rated less (the investor often has a choice AA to BBB or less, there is a spread between issued and underlying and it that spread that is the investor’s income.
The spread is generally locked in for the life of the deal at the beginning. The underlying assets if not already floating rate paper are swapped to create floating rate – LIBOR plus say 2.5 and the issued paper is issued at LIBOR plus say 1.25. The resulting 100 bps of spread flows to the equity holder / investor. Total equity of $10 million may support as much as $250 million in issued debt. In this example 1% spread on $250m is a 25% possible return on $10 million. The rating agencies know and the investor plans for an expected default rate. That rate (some percent of the total defaulting in the 10 to 12 year life of a deal and which drives the quality ratting) lowers the possible return to a particular targeted or expected return. Any default greater will decrease the expected return and any default less than will increase it.
These deals take out the risk of interest rate moves and take out the risk of the change in spreads and provide the opportunity to be paid for assuming just default risk. They also provide effective leverage without debt and without putting the investors entire balance sheet at risk.
Timing (strategic investment) is essential here since sufficient spread must exist to make them feasible in the first place and it must exist at the same time as the risk of default for the underlying is low (or at least acceptable). Once the investor is comfortable with the concept a decision can be made on the advisability of a particular underlying asset and a manager(s) for the deal. The actual timing of the deal will be dependant on the market. Today the CLO with bank loans underlying is the best.