CBO, CBOs: Collateralized Bond Obligations

 

 

Collateralized Bond Obligations or CBOs are investment grade bonds backed by a pool of junk or low quality bonds which are not investment grade on a standalone basis. The pooling of several types of credit quality bonds results in adequate diversification to warrant an investment grade. These bonds are categorized into various tiers with varying degrees of risk and varying interest rates.[br]

 

Issue Process of CBO, CBOs: Collateralized Bond Obligations

The issuance of collateralized bond obligations involves the transfer of a bank’s or financial institution’s portfolio of low rated bonds to a specially created corporation or trust called the Special Purpose Vehicle (SPV). This trust then uses the transferred bonds as collateral for the issuance of CBOs in two or more levels called tiers or tranches. Each tranche carries a different level of risk and rate of interest.

 

The senior-most tranche of a CBO is considered the safest since the interest and the principal payments are made in order of seniority. However, losses are first borne by the junior-most CBOs and then the upper tranches. To compensate for the high risk carried by the junior tranches, the coupon payments or the interest rates offered on them are higher than those offered for the senior tranches. Some issuers offer the junior tranches of CBOs at lower prices to compensate for the additional default risk.

 

Participants in CBO, CBOs: Collateralized Bond Obligations

The various participants in a CBO transaction include investors (banks, hedge funds, and wealthy individuals), the underwriter, the asset manager, the trustee, the collateral administrator, attorneys and accountants.

 

An underwriter’s job is to act as the manager and the structure designer of a CBO. It works with credit rating agencies to determine the securities rates and with the law firm to create a special purpose vehicle. The underwriter also helps in deciding the trading restrictions that are put on the securities being issued apart from pricing the various tranches of CBO.[br]

 

The asset manager’s responsibility is to choose the basic underlying portfolio of assets and to reinvest funds to modify or expand the portfolio from time to time.

 

The trustee of the SPV holds the titles to the assets used as collateral and also serves as their administrator. While attorneys ensure compliance with the requisite securities laws, accountants perform due dilligence on the asset portfolio.