Arbitrage CDO Issuance Activity (USD mn)
010,00020,00030,00040,00050,00060,000198819891990199119921993199419951996199719981999Mkt ValueCash Flow
Source: DB Global Markets Research
Table of Contents
Introduction:Lay of the land..............2Cash Flow CDOs:Managing Default Risk.4Market Value CDOs:Managing Price Risk...13Risk & Return:Relative ValueConsiderations............18Emerging Issuesand Alternative CDOSectors.......................21Appendix:Cash Flow vs. MarketValue CDOs................23Bibliography................24
Collateralized debt obligations have been around for over a decade, but ithas only been in the past three years that issuance volume has jumpedsignificantly, from about $20 billion to over $100 billion. Issuance hassoared due to investor demand and innovation.
There are two basic types of CDOs – balance sheet CDOs, which aredone by banks for regulatory capital purposes, and arbitrage CDOs, wherehigh yielding collateral is securitized and financed by relatively low costinvestment grade bonds.
A key sector of the market today is arbitrage CDOs backed by US-issuedhigh yield assets, otherwise known as CBOs. These transactions accountfor about 55% of total CDO volume but nearly 75% of deals.
Cash flow CDOs are structured so that investment grade bonds canwithstand the worst default experience seen over the past 30 yearswithout suffering losses. Market value CDOs are structured so thatinvestment grade bonds backed by below investment grade assets canwithstand multiples of the worst historic price volatility.
CDO bonds carry credit risk similar to comparably rated corporate bonds,but offer substantially wider spreads across the credit spectrum.
March 21, 2000
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John F. Tierney
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Managing Director, Head ofGlobal Markets Research
The Arbitrage CDO Market
Cash flow & market value CDOs lead the way
G l o b a l M a r k e t s R e s e a r c h R e l a t i v e V a l u e