Collateralised and securitised debt
22.4 Attribution on securitised debt
22.1 INTRODUCTION
Collateralised and securitised debt forms some of the more complex types of instrument traded in the fixed income markets. Fortunately, it is seldom necessary to delve into their details in order to treat them in attribution reports.
22.2 SECURITISATION
Securitisation is the process of pooling various types of debt, such as residential and commercial mortgages, car loans and credit card debt, into new types of liquid security such as bonds and pass-through securities. The most commonly encountered securitised bond is a mortgage-backed security, which, as the name implies, is backed by a pool of residential mortgages.
Since the bond is based on the cash flows from a large number of mortgages, the risk of any one mortgage defaulting is low, so risk-averse investors will prefer to invest in the securitised debt rather than the underlying issues. The securitised debt can also be sold in smaller parcels than would be possible with the underlying debt, increasing the number of potential investors in the security.
22.3 COLLATERALISED DEBT
A collateralised debt obligation, or CDO, is a pool of financial assets with varying characteristics that generate revenue over time. These assets are typically bonds, mortgages or other types of security but may also include tranches from other issued CDOs. In other words, they are securities that are securitised on other assets, rather than physical assets in their own right.
The CDO repackages the cash flows from these assets into different tranches that can be sold on to investors. The tranches are structured so that the most creditworthy tranches have first claim on the cash flows and underlying collateral if any of the assets default. As a result, these senior tranches are assigned a higher credit rating than the mezzanine, junior and toxic waste tranches, which offer progressively higher yields to compensate the purchaser for their additional default risk.
The appeal of CDOs for the issuer is that they offer a way to parcel up debt that would not be otherwise saleable, either for reasons of creditworthiness or liquidity.1 Their appeal to the buyer is that they also offer higher yields than corporate debt with the same credit rating.
Many types of CDOs have been traded in the marketplace, depending on their underlying asset class. Table 22.1 shows some of the most commonly encountered.
Table 22.1 Types of CDO
| Acronym | Type | Collateral |
|---|---|---|
| CLO | Collateralised loan obligation | Leveraged bank loans |
| CBO | Collateralised bond obligation | Leveraged fixed income securities |
| CSO | Collateralised synthetic obligation | Credit derivatives |
| SFCDO | Structured finance CDO | Structured products such as asset-backed securities and mortgage-backed securities |
| CRECDO | Commercial Real Estate CDOs (CRE CDOs) | Commercial real estate assets |
| CBO | Collateralised bond obligations | Corporate bonds |
| CIO | Collateralised Insurance Obligations | Insurance contracts |
| CDO2 | CDO-squared | Tranches issued by other CDOs |
| CDOn | CDOn | Tranches issued by other CDO2, at (possibly) many levels |
22.4 ATTRIBUTION ON SECURITISED DEBT
For the attribution analyst, the main concern with these security types is knowing what cash flow structure should be used to model the difference tranches. Fortunately, they almost always follow the standard patterns of a bond or FRN. Given the pricing and cash flows of each tranche, the techniques described earlier in the book can be used to include such securities into an attribution report.
1 In the aftermath of the 2010 global financial crisis, many commentators compared CDOs to sausages: tasty, but one is better off not knowing their ingredients.