Default On The Underlying Portfolio Of Bonds example essay topic

CBO CBO's (collateralized bond obligation) are sometimes called CDO (D = debt) and look somewhat like CMO's (M = mortgage). This would be a private equity investment because we would own the equity of the issuer not the CBO issued bonds. We are talking about a vehicle that owns some underlying asset, such as investment grade bonds (some use high yield but I suggest only looking at investment grade), and then issues bonds backed by those assets. The difference between the income from the underlying asset (rated A+ to A-, -the investor's choice) and the bonds that are issued rated is the return on our investment which we expect to be about 12 to 17%.

Our investment would be much smaller than the total number of bonds so that the (about) 1% spread on the total is the 12 - 17% on the investment. Mechanically, the process is to invest a sum, say $10 million into a vehicle created for this purpose and then buy $250 million of bonds averaging A and to issue $240 million of bonds rated. This is facilitated by an investment banker. Over capitalization and the fact that a portion of the issued bonds (about 10-15%) are subordinated permits the rating by Moody and or S&P. This structure provides effective leverage without debt and avoids our obligation beyond the initial investment. This is by no means risk free but most risk is eliminated or strongly mitigated except one. The prime risk that remains is one of default on the underlying portfolio of bonds and much of the evaluation of a particular deal rests in the evaluation of "what if" when the default rate is different than expected.

The average default rate of a pool of bonds can be reasonably well addressed by the score given by Moody and is reflected in the rating given to a pool. This can be mitigated some by the manager of the underlying portfolio, but not completely eliminated. This default risk is the risk we are being paid to take and the return reflects the uncertainty of the actual rate and therefore the actual return. There is liquidity through full or partial unwinding of the portfolios- calling outstanding issued bonds through the sale of underlying bonds. The pool is self-liquefying after a time, generally 7-12 years.

The entire process is customizable so that risk can be added or subtracted to achieve a certain return goal. The lower the goal the more certain its achievement, say - 12% plus or minus one. The higher the goal the less certain, say -- 17% plus or minus five. The viability of a CBO investment is dependent on certain spreads and the availability of bonds to acquire and the appetite for the issued bonds. While it may be good in concept the available spreads and therefore return targets may not be sufficient for the risks, at present..