Collateralized debt obligations, also known as CDO’s, offer businesses a venue for raising capital at low interest rates even when traditional bank loans aren’t available. It wasn’t long ago that being turned down by the banks for a business loan meant that access to capital via borrowing simply wasn’t an option. Now, as CDO’s are increasingly accepted by lenders and investors around the world, businesses can access capital at costs comparable to companies in the “Fortune 500”.
Attracting these willing lenders/investors is accomplished using the structure of a typical CDO where “tranches” are set up so that investors have unequal claims to interest and principle. Interest payments are also unequal as investors in the subordinated tranches receive higher coupons for accepting a higher level of risk. This runs counter to simple “pass-through” notes where all investors have equal standing in terms of receiving principle and interest payments.
In their most basic form a senior tranche sits above and is protected by subordinated tranches. These subordinated tranches buffer the senior tranche from losses to the point where the senior tranche of the CDO will not suffer losses until the subordinated tranches are wiped out. This protection can often result in a AAA rating for senior debt, even when the issuing company’s overall credit rating is much lower.
Despite their underlying protection, AAA rated senior tranches can feel the effects of trauma in the subordinated tranches if defaults begin to occur. In fact, a tranche’s AAA rating can be endangered as the protection from subordinated tranches is eaten up by defaults. Should defaults accelerate, the note would lose its AAA rating as risks to the holders of the senior tranche increase.
Collateralized debt obligations offer access to funding that may not be available via traditional means. The complexity of their structure, however, will necessitate advice and implementation from experienced professionals like Dmitrij Harder and the team at Solvo Group. This type of professional handling can ensure that a CDO is structured to benefit both lenders/investors and businesses seeking capital for operations and/or expansion.