Synthetic CDO

A synthetic CDO is a collateralized debt obligation (CDO) that invests in credit default swaps (CDSs) or other noncash assets to obtain exposure to a portfolio of fixed income assets. 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.

In a synthetic CDO, all tranches will receive periodic payments based on the cash flows from the credit default swaps. Normally, the payoffs of synthetic CDOs are only affected by credit events associated with CDSs. 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 are a modern advance in structured finance that can offer extremely high yields to investors. However, investors can be on the hook for much more than their initial investments if several credit events occur in the reference portfolio.

Tranches are also known as slices of credit risk between risk levels. Normally, the three tranches primarily used in CDOs are known as senior, mezzanine and equity. The senior tranche includes securities with high credit ratings and tends to be low risk and therefore have lower returns. Conversely, an equity-level tranche carries a higher degree of risk and holds derivatives with lower credit ratings, so it offers higher returns. Although the equity-level tranche may offer higher returns, it is the first tranche that would absorb any potential losses.

Tranches make synthetic CDOs attractive to investors because they are able to gain exposure to CDSs based on their risk appetite. For example, assume an investor wishes to invest in a high-rated synthetic CDO that included U.S. Treasury bonds and corporate bonds that are rated AAA, the highest credit rating offered by Standard & Poor's. The bank can create the synthetic CDO that offers to pay the U.S. Treasury bond's yield plus the corporate bonds' yields. This would be a single tranche synthetic CDO that only includes the senior-level tranche.

Synthetic CDOs were first created in the late 1990s as a way for large holders of commercial loans to protect their balance sheets without selling the loans and potentially harming client relationships. They have become increasingly popular because they tend to have shorter life spans than cash flow CDOs, and there is no extended ramp-up period for earnings investment. Synthetic CDOs are also highly customizable between the underwriter and investors.