Collateralized Bond Obligation - Explained
What is a Collateralized Bond Obligation?
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Table of ContentsWhat is a Collateralized Bond Obligation?How Does a Collateralized Bond Obligation Work?Example of Use in Bond PortfoliosAcademic Research on Collateralized Bond Obligation
What is a Collateralized Bond Obligation?
A collateralized Bond Obligation (CBO) refers to an investment-grade asset that is backed by assets that are not investment-grade, otherwise called junk bonds. The pool of junk bonds that back a CBO often have high risks, the higher their risks, the higher the interest rates an investor will earn on the CBO. Usually, the junk bonds that back a CBO have different levels of risks which aid diversification of the asset and its qualification as an investment-grade asset. Collateralized bond obligations (CBOs) are issued as a form of debt financing that transforms junk bonds into investment-grade assets.
How Does a Collateralized Bond Obligation Work?
The issuer of a CBO is referred to as a protection buyer. For an issue of CBO, underlying collateral is required, often low-rated bonds which are otherwise called junk assets. CBOs are credit derivatives and are issued in tiers or tranches, with each tier containing a different level of risk and interest rate. For instance, it is possible to have a CBO that contains tiers or tranches namely; senior debt, mezzanine debt, and stocks. Depending on the tier each of these categories of junk bonds appears, their contribution to the portfolio varies. Junk bonds with higher levels of risk attract higher interest rates than those with low-risk levels.
Example of Use in Bond Portfolios
Generally, junk bonds have low ratings with a high level of risk. However, buyers of CBOs receive higher returns or compensations when the junk bonds have high risks, this is because, the higher the risks, the higher the interest rate paid on the bond. Junk bonds serve as the collateral in a CBO and they offer diversification of investments, risks, and returns. Collateralized bond obligations (CBOs) are issued in tiers in order to offer buyers different levels of risks and compensations.
Academic Research on Collateralized Bond Obligation
- Default risk sharing between banks and markets: the contribution of collateralized debt obligations, Franke, G., & Krahnen, J. P. (2007). In The risks of financial institutions (pp. 603-634). University of Chicago Press. Nowadays, credit securitization and bond portfolios have become much popular in banks. In Europe and the US, the volume of CLOs (Collateralized Loan Obligations) and CBOs (Collateralized Bond Obligations) has increased to a greater extent. This progress has also led to raising many problems on the micro as well as macro level. In this paper, the authors discuss some problems on the micro level, especially the influence of CLO transactions on the risk-taking of the banks. They explain the default risk sharing in markets and banks and also, what is the role of CDOs (Collateralized Debt Obligations).
- The credit rating crisis, Benmelech, E., & Dlugosz, J. (2010). NBER macroeconomics annual, 24(1), 161-208. This paper provides information about the effects of the Credit Rating Crisis from 2007 to 2008. The authors discuss how it influenced the credit rating of structured finance. They explore the reasons for rating collapse. They state the rating performance of related products since 1983. They argue on this performance of structured finance with information on all corporate bonds that Moodys rated during the crisis. They use the corporate bonds data as a benchmark for the right credit rating distribution having an economic foundation.
- On default correlation: A copula function approach, Li, D. X. (1999). This article addresses the default correlation problem. The authors use a random variable named Time Until Default. It refers to the survival time of every default financial instrument or entity. They argue on the Copula Function Approach to identify the survival times joint distribution after its marginal distributions, for example, asset swap spreads, risky bond prices, etc. The recent Credit Metrics Approach (CMA) to default correlation by asset correlation equals to standard Copula Function. Lastly, they elaborate with a numerical example to use Copula to find the credit derivatives valuation, e.g. first to default contracts and credit default swaps.
- Questions and answers about the financial crisis, Gorton, G. B. (2010). (No. w15787). National Bureau of Economic Research. During the phase of the economic crisis, all the bond prices declined. This was because of the banking panic. The firms and institutional investors refused to rebuy collateralized short term agreements, also known as the repo. The Federal Reserve System used to count this as money. They also stopped renewing sales. In this scenario, firms had to sell assets, decrease prices of bonds and face loss. This Parallel or Shadow Banking System is genuine like a traditional regulated banking system. It is a funding foundation for them. If it would stop working, traditional banks would stop lending and credit.
- A Primer on the Role of Securitization in the Credit Market Crisis of 2007, Martin, J. (2009). This paper highlights the securitization role in the credit market, particularly, during the credit crisis of 2007 to 2008. The author observes that the Originate to Distribute through securitization model dominated the credit markets of the United States. There are several benefits of this model but it accompanied fatal principal-agentthe issue in the process of credit screening. There arouse Market for Lemons issue which collapsed the market. The market of mortgage back securities collapsed. As a result, the affected financial institutions failed and banking panic prevailed.
- Did structured credit fuel the LBO boom?, Shivdasani, A., & Wang, Y. (2011). The Journal of Finance, 66(4), 1291-1328. The boom of LBO (Leveraged Buyout) 2004-2007 was due to the CDOs (Collateralized Debt Obligations) growth and other types of securitisation. The banks, that were actively dealing in the structured credit underwriting, started lending more for LBOs. This showed that the lending policies of banks were associated with CDO and LBO markets. These loans were linked to more use of debt, weaker covenants and lower spreads. Credits which were financed via structured credit markets didnt worse riskier deal structures, overpayment and LBOs. Securitization markets changed the access of banks to capital and influenced their lending policies.
- Modelling default correlation in bond portfolios, Davis, M., & Lo, V. (2001). Mastering risk, 2(1), 141-151. CBO structure performance depends on defaults correlations bonds medium-sized portfolio. The authors present 2 types of purely probabilistic models. It is possible that an issuers default in a specific industry triggers other issuers default using an Infection Mechanism. As infection moves up, the default distribution moves the variance up, heavier tails and the concentration risk quantifies. The Continuous-Time Stochastic Process, also known as Enhanced Risk Model, depicts the same features. The authors conclude with a discussion on parameter estimation and implementation of these models in the analysis of CBO.
- On the design of collateralized debt obligation-transactions, Franke, G., Herrmann, M., & Weber, T. (2007, January). In EFA 2007 Ljubljana Meetings Paper. How the CDO (Collateralized Debt Obligations) transactions are designed that they grow strongly? The purpose is to maximize profits depending on the requirements that the rating agency and investors impose. The authors make an analysis of European transactions. The findings are that the asset pool quality has a vital role in this regard. The features of the originator have a small role. If the asset pool quality is lower, the originator takes a high 1st loss position. The old least information sensitive part is not sold. Its size decreases with asset pool quality.
- What is structured finance, Jobst, A. A. (2005). An Analysis of Derivatives, Securitization and Islamic. This article provides detailed information on structured finance and its importance in an economy. It works with financial lending instruments to reduce serious risks associated with complex assets. The author describes the downgrading of Ford Motor Co. and General Motors Corp in April to non-investment status and the effect of complex structured finance methods on financial stability. This paper briefs structured finance to discuss the regulatory challenges the asset exposure assembly poses as well as the transfer of credit risk in the transactions of complex structured finance.
- The role of corporate bond markets in the Korean financial restructuring process, Oh, G., & Rhee, C. (2002). Korean crisis and recovery, 229. The Asian financial crisis had, unexpectedly, severe impact on the Korean economy. However, it managed to move towards recovery in a short time span. Korean Gross Domestic Product sharply dropped from 7% to 6.7% in 1998. Surprisingly, from 1999 to 2000, it reached to 8% and then 10.7 % remarkably. One of the reasons for its fast revival was the use of corporate bonds. It caused the rapid flow of funds. In this research, the authors discuss the financial restructuring process in Korea. They investigate what is the role of markets, dealt in the corporate bonds in this restructuring process.
- Collateralized Debt Obligationsan overview, Royer, M., & Coordination, V. P. P. (2011). on-line]. pdf, 2. This paper is an overview of the CDOs (Collateralized Debt Obligations). From the perspective of investment decision and risk management, making an analysis of the CDOs is complex enough. This is because just the credit portfolio will not be analyzed. The investor will not know which collateral to buy in managed deals. Also, it will need to examine the cash flow structure or waterfall, the tranche and risk source for every position given migrations and defaults. The authors suggest using sophisticated portfolio credit risk techniques. Also, appropriate interaction, monitoring and diligence are required, because sponsors may involve in manipulation.
- Financialization and the consumer credit boom, Langley, P. (2008). Competition & Change, 12(2), 133-147. The financialization focuses on the massive growth of ownership claims on all instruments. It has also made the research possible associating the financial market changes to disciplinary shift in corporate governance and management. However, future work can be done from the perspective of cultural political economy and in Anglo American economies, the financial market changes are associated with the consumer credit boom. These transformations also arise in daily financial self-government. Prudence and thrift are not dominant on individual security and freedom, but the management, entrepreneurial meeting and manipulation of due obligations displace them.
- Asian bond markets: the role of securitization and credit guarantees, Tran, H. Q., & Roldos, J. (2003, July). In The 2nd ASEAN Central Bank Governors Meeting, Bangkok (Vol. 8, No. 2). This study throws light on the role of credit guarantees and securitization in the bond markets of Asia. Since the financial crisis of 1997 to 1998 in Asia, bond markets on the local level have significantly grown. The growth of local bond markets may be a vital source of reducing exchange rate risks, countries exposure to maturity and abrupt stops in access to global capital markets. Local bond markets also have a great role in diversifying funding sources, specifically for corporate debtors. Finally, the authors suggest possible reforms and policy actions for the growth of Asian bond markets.